|
|
RECENT ESTATE, GIFT & TRUST CASES
Robert E. McKenzie, Esq.
©1999
Section 6011
Land Corporation That Never Filed Returns Is Liable for 50 Years of Taxes and Interest, but Not Penalties.
The Front Royal and Riverton Improvement Company (FRRIC) was incorporated in 1890, under the laws of the Commonwealth of Virginia, for the purpose of acquiring real estate and selling property and shares of stock on an installment basis. The corporate plan of selling lots and stock to finance corporate operations failed to produce enough income to meet FRRIC's financial obligations as they became due. In 1894, a creditor's suit was filed in county court, precipitating receivership of the corporation. From the inception of this receivership, various court-appointed receivers "slowly, perhaps glacially, liquidated the FRRIC property, consisting primarily of parcels of real estate located in and around Front Royal, Virginia."
Ron Lewis Napier was appointed FRRIC's special receiver in 1986. Until March 1994, neither Napier nor any of the receivers who preceded him had ever filed a federal income tax return for, or paid any federal income taxes on behalf of FRRIC. However, Napier "diligently sought to ascertain the tax filing status of the FRRIC throughout his tenure as Special Receiver," making repeated inquiries of the IRS and receiving less than helpful responses. When the instant action was filed, the IRS was FRRIC's only creditor. As of September 1994, FRRIC's assets totaled $120,000, and the corporation was indebted to the United States for federal income taxes, penalties, and interest for the years 1942 through 1992. The only tax returns filed by FRRIC covered 1993 and 1994.
Circuit Court Judge John E. Wetsel Jr. has held that the United States has a valid and enforceable claim against FRRIC for federal incometaxes and interest due for the years 1942, 1950-1958, 1962, and 1964-1992, but that FRRIC is not liable for penalties on those liabilities. Napier "discharged his duties as Special Receiver of FRRIC with the prudence and diligence the law required of him," Judge Wetsel wrote. And, the court reasoned, "On the unique facts of this hoary case, it cannot be said that
the preceding receivers were less prudent. Therefore, no penalties are due the IRS on the delinquent taxes."
"The United States has a valid and enforceable claim against the petitioner for federal income taxes and interest, due and owing for the years 1942, 1950-1958, 1962, and 1964 through 1992. When this receivership was ordered by the Circuit Court of Warren County in 1894, the ill fated Czar Nicholas II ascended to the throne of imperial Russia, and Nikita Khrushchev, who would preside over the regime which overthrew that Czar and whose bellows would rock the government whose tax agency now seeks to grasp the funds of the receivership, was born. About the time of the First World War, the receivership appears to have assumed a life of its own, and, like Dickens' Jarndyce v. Jarndyce, the Riverton Receivership passed from generation to generation. Since the receivership's inception, this country has been engaged in numerous wars, a great depression, and experienced immeasurable social and economic changes. Receivers came and went, many of whom were prominent and respected members of the local bar, and each succeeding receiver plodded stolidly along in the footsteps of his predecessor. In 1913, the federal income tax was enacted, and thereafter each successive receiver, except for the last one, unwittingly failed to pay federal income taxes. The IRS, which was not even embryonic in 1894, now is in the full strength of its adulthood, and armed with the rectitude of omniscient hindsight and an insatiable appetite, now wishes to elevate the receivers' nonpayment of the federal income tax to culpable maladministration, so that all of the funds of the receivership will be paid to the Internal Revenue Service.
Nineteen forty-two, the first year that
the IRS claims that taxes are due in this case, saw the apogee of the Axis
advance in World War II, and none of the lawyers or the judge in this case had
yet been born. The theory of the IRS is that sometime between 1913 and 1942, a
reasonably prudent receiver, under the circumstances of this case would have
known, or in the exercise of reasonable diligence should have known, that
income taxes were due the IRS. The evidence does not show when this Damascene
revelation should have occurred to the receiver. Even in the last decade of the
twentieth century, not all lawyers are tax lawyers, and the labyrinthine
provisions of the internal revenue code and its attendant regulations have
spawned a host of lawyers, accountants, and other specialists, whose sole
vocation is the interpretation and application of the complexities of the
United States Internal Revenue Code. Consonant with this reality, the United
States Department of Justice has a "Tax Division," whose expertise
was enlisted in this Case." Circuit
Court of Warren County, Virginia, Front Royal And Riverton Improvement
Company V. All Shareholders Of, Creditors Of, et ( 1995) 1995 TNT 73-8
Section 170
STOCK GAIN IS TAXABLE TO DONORS; GIFT WASN'T COMPLETE BEFORE RIGHT TO CASH WAS FIXED.
The Ninth Circuit, affirming the Tax Court on an issue of FIRST IMPRESSION FOR THIS CIRCUIT, has held that individuals who donated stock to charitable organizations immediately before the corporation merged in a tender offer are taxable on the stock's gain under the "anticipatory assignment of income" doctrine.
Roger and Sybil Ferguson and their children, including Michael, owned 18 percent of American Health Companies Inc. (AHC). Roger, Sybil, and Michael were also on AHC's board of directors. In December 1987 another AHC director contacted an investment company about a possible sale of AHC, and AHC began receiving purchase offers in early 1988. In July AHC entered into a merger agreement with CDI Holding Inc. and CDI's subsidiary DC Acquisition Corp., which made a tender offer on August 3.
In August Michael, Roger, and Sybil executed donation-in-kind records stating their intentions to donate AHC stock to the Church of Jesus Christ of the Latter Day Saints. The Fergusons then placed AHC stock into new brokerage accounts and created three charitable foundations. By the end of August, more than 50 percent of the AHC shares had been tendered.
On September 8 their stockbroker transferred some shares from the Fergusons' accounts to a church account and some shares to the charitable foundations. On September 9 the Fergusons exchanged large amounts of their AHC stock for shares of CDI stock and tendered the remaining AHC shares in accordance with the tender offer. Also on September 9 the three charities tendered the shares they had received.
The IRS determined that the Fergusons were taxable on the gain derived from the AHC shares donated to the charities. The Tax Court agreed with the IRS, rejecting the Fergusons' contention that the gifts were completed when they delivered the shares to the stockbroker.
Circuit Judge Herbert Y.C. Choy held that the charitable contributions were not completed before the stock interests had "ripened" into a fixed right to receive cash on September 9. On that day, the appeals court concluded, the gifts were completed when the Fergusons executed final letters of authorization for the transfers nominally made the day before. The court rejected the Fergusons' allegation that the stockbroker had acted as the charities' agent.
Regarding the anticipatory assignment of income, Judge Choy noted that this court has not addressed the question of when a right to receive income has "ripened" for tax purposes. A court must consider the "substance of events," Judge Choy wrote, "to determine whether the receipt of income was practically certain to occur . . . . While the finding of a mere anticipation or expectation
of the receipt of income [is] insufficient to conclude that a fixed right to income existed, . . . the overall determination must not be based on a consideration of mere formalities and remote hypothetical possibilities."
The Ninth Circuit agreed with the Tax Court that the stock had ripened from a corporate interest into a fixed right to receive cash by the end of August, when more than half of the AHC stock had been tendered. The Fergusons pointed out that in most anticipatory-assignment cases, some formal shareholder vote occurred by the time the stock was deemed to have ripened, but Judge Choy found nothing in those cases suggesting that such a formality is a prerequisite.
The Fergusons argued that several occurrences might have blocked the merger before DC Acquisition accepted the tendered stock on September 12, but the court found it unlikely that any of the parties would have backed out after August 31.
Raising tax-policy issues, the Fergusons contended that because their actions were not unlawful, they were permitted to structure the transaction to avoid tax (not evade tax). "However," Judge Choy
wrote, "simply because the Fergusons have the right to choose the least costly path . . . upon which to walk, they do not have the right to be free from taxation if they decide to walk the line between what is and what is not permissible, and happen to stray across it."
As to the Fergusons' lament that there is no fine line, Judge Choy noted the danger of "walking the line between tax evasion and tax avoidance," and he remarked, "Any tax lawyer worth his fees would not have recommended that a donor make a gift of appreciated stock this close to an ongoing tender offer and a pending merger, especially when they were negotiated and planned by the donor."
Michael Ferguson, Valene Ferguson, Roger N. Ferguson and Sybil Ferguson,
V. Commissioner of Internal Revenue, 83 AFTR2d Par. 99-648(CA9 1999)
Section 402
Trust Beneficiary's Tax Qualified Plan Distributions to Widow's IRAs Are Rollovers
The Service has ruled that a widow may rollover distributions from her
husband's qualified plans into her own IRAs tax-free. At the time of his death
in 1996, the participant had been receiving minimum required distributions
(MRDs) from his qualified retirement plans based on his life expectancy. In
1997, one plan was terminated and his plan assets, less the MRD for 1997, were
transferred to four IRAs in the widow's name, each naming one of her children
as designated beneficiary. The widow wishes to transfer the proceeds of the
remaining pension plan to four more IRAs, treat them as her own, and calculate
the MRDs from these IRAs based on the joint lives of herself and the designated
beneficiaries. The Service ruled that the widow didn't have to include the
rolled over amounts in income, as long as the required minimum distribution
period conforms to the incidental benefit rules of Reg. Section 1.401()a)(9)-2.
LTR 199928040
Code Sec. 483
Stock Sales for less than Fair Value -- Below-market Interest.
In estate tax refund action, govt. was granted summary judgment regarding
revaluation of decedent's installment sale of stock to trust at below-market
interest as taxable gift: Code Sec. 483 's interest safe harbor didn't apply.
Code Sec. 483 plainly applied only when stated interest rate was less than safe
harbor rate; and "for purposes of this title" meant it applied to
interest/principal characterization, not present value determination of payment
as whole. Also, legislative history supported Code Sec. 483 's inapplicability;
and annual gift tax exclusion wasn't available where gift's value to particular
trust beneficiary wasn't determinable. (Lundquist v. U.S., DC NY, 83
AFTR 2d 99-1471 )
Code Sec. 2001
Gift Valuation.
This document contains a correction to the notice of proposed rulemaking,
REG-106177-98 (1999-12 I.R.B. 25), published in the Federal Register on
December 22, 1998 (63 F.R. 70701). (Ann 99-28 United States Tax Reporter ¶
144,338 )
Tax Rate Increase; Retroactivity -- Apportionment, Due Process and Takings Clause Violations; ex Post Facto Laws.
District court properly dismissed estate and gift tax refund action that
challenged constitutionality of retroactive increase of federal estate and gift
tax rates under '93 OBRA. Rate change wasn't imposition of wholly new tax and
didn't violate due process where, despite effect on estate planning and general
disfavor for retroactivity, change was rationally related to legitimate purpose
of raising revenue, and lack of curative aspect was irrelevant. Also, 8-month
retroactivity period wasn't so severe to effect unconstitutional taking; rate
change didn't convert taxes to direct taxes requiring apportionment; and court
lacked jurisdiction over ex post facto claim. (Quarty v. U.S., CA 9, 83 AFTR 2d
99-1562 )
Constitutional Challenges -- Direct Tax.
Portion of estate tax attributable to property paid to satisfy estate taxes
wasn't unconstitutional direct tax on property's value: distinction between tax
on property transferred to heirs vs. tax on property transferred to govt. to
pay tax was insignificant; challenge to "tax inclusive" feature was
meritless; and termination of interest in assets at death was taxable event.
(Estate of Helen Bolton Jameson v. Commissioner, TC Memo 1999-43, TC Memo
1999-043 )
Proposed Regs on Meaning of Adequate Disclosure for Running of Limitations Period for Gifts and Ban on Revaluing Earlier Gifts
REG-106177-98; Prop. Reg. § 20.2001-1, Prop. Reg. § 25.2504-2, Prop. Reg. § 301.6501(c)-1
The period of assessment doesn't close for a gift made in a calendar year ending after Aug. 5, '97, or with respect to any increase in gift tax required under Code Sec. 2701(d), unless the gift is adequately disclosed on a gift tax return. ( Code Sec. 6501(c)(9)) If a gift is adequately disclosed and the limitations period runs on the gift, it can't be revalued for purposes of determining gift tax on a later gift ( Code Sec. 2504(c)) or estate tax. ( Code Sec. 2001(f)). Proposed regs would prescribe what actions would be needed to meet these adequate disclosure requirements.
List of required information. The proposed regs would provide a list of information that, if applicable to a transaction, would have to be reported on a gift tax return, or a statement attached to it, for the transaction to be considered adequately disclosed for purposes of starting the assessment period. The required information would have to completely and accurately describe the transaction and would have to include the nature of the transferred property; the parties involved; the value of the transferred property; and how the value was determined, including any discounts or adjustments used in valuing the transferred property. ( Prop. Reg. § 301.6501(c)-1(f)(2))
Specific rules would apply for transfers of interests in entities that are not actively traded. ( Prop. Reg. § 301.6501(c)-1(f)(2)(iii))
The return would have to disclose the facts affecting the gift tax treatment of the transaction in a manner that reasonably would be expected to apprise IRS of the nature of any potential controversy regarding the gift tax treatment of the transfer. In lieu of this statement, the taxpayer could provide a statement of any legal issue presented by the facts. Also, the taxpayer would have to provide a statement of any position taken by him that's contrary to any temporary reg, final reg or revenue ruling. ( Prop. Reg. § 301.6501(c)-1(f)(2)(vi))
Complete and incomplete transfers. Adequate disclosure of a transfer that is reported as a completed gift on a gift tax return would begin the running of the statute of limitations even if the transfer were ultimately determined to be an incomplete gift. Thus, if a donor reported a transfer on a gift tax return as a completed gift for gift tax purposes, the period for assessing a gift tax for the transfer would begin. ( Prop. Reg. § 301.6501(c)-1(f)(4)) If IRS didn't examine the transaction before the expiration of the running of the statute of limitations, the transaction would be treated as a completed gift as reported on the return. If IRS, upon examination, disagreed with the donor's characterization of the transaction, and the issue remained unresolved through the administrative process, the donor would be sent a final notice of determination and could seek a declaratory judgment on the matter under Code Sec. 7477.
On the other hand, if a donor initially reported a transfer as an incomplete gift, even if adequately disclosed, the statute of limitations wouldn't begin to run until the donor reported the transfer as a completed gift. ( Prop. Reg. § 301.6501(c)-1(f)(4)) IRS would have three years from the date of filing of the subsequent gift tax return disclosing the completed gift to make any assessment.
Ban on revaluing earlier gifts. The proposed regs would make it clear that
the rule of Code Sec. 2504(c) and Code Sec. 2001(f) would not preclude IRS from
making adjustments that are not related to value, such as the erroneous
inclusion or exclusion of property for gift tax purposes. For example, if an
individual claimed a gift tax annual exclusion for a transfer that IRS was
barred from revaluing because the taxpayer met the statutory and regulatory
requirements, that bar wouldn't prevent IRS from claiming that the transfer
didn't qualify for the annual exclusion. ( Prop. Reg. § 20.2001-1(f)).
Code Sec. 2002
Liability -- Personal Representative; Employee Stock Ownership Plan -- Secondary Liability. Estate's personal representative was granted summary judgment regarding estate's liability for ESOP's assumed portion of estate taxes: former Code Sec. 2210(a)(3) , which clearly discharged executor in representative capacity from liability for ESOP's obligation, discharged estate as well. Completely shifting liability from estate to ESOP for its assumed portion of taxes was consistent with former Code Sec. 2210(c) and Code Sec. 2210(d) , which provided alternative secondary basis for collecting ESOP's tax liability. Also, although not controlling, both legislative history and IRS's instructions for estate tax return filing generally supported complete shift of liability with respect to Code Sec. 2210 ESOP election. (Wilkes v. U.S., DC FL, 83 AFTR 2d 99-1759 )
Code Sec. 2011
Estate Taxes -- Marital Deduction -- State Transfer and Inheritance Taxes.
IRS correctly determined that marital deduction didn't include Idaho
transfer and inheritance taxes chargeable against voting stock bequest to
credit shelter trust trustees: no transfer or inheritance taxes had yet been
paid to Idaho; and voting stock revaluation required recalculation. (Estate
of Richard R. Simplot v. Commissioner, 112 TC No. 13 )
Code Sec. 2031
Estate Taxes -- Stock Valuation; Closely Held Corps. -- Discounted Cash-flow; Absorption Discount.
Tax Court valued decedent's stock interest in family real estate operating
corp. at book value: although IRS improperly claimed entity-owned real estate
wasn't eligible for absorption discount, taxpayer's expert's estimated 23%
discount rate for certain unimproved properties was reduced where expert
improperly assumed all properties would have competed in marketplace, included
all properties in discounted cash-flow analysis, didn't explain absorption
period for unrestricted and wetlands categories, and used postvaluation date
sale. Also, in estimating stock's value, IRS's expert gave corp.'s net asset
value disproportionate weight, while taxpayer's experts properly weighted
latest-year earnings, and appropriately accounted for net asset value in market
approach using REIT's. (Estate of Lynn M. Rodgers v. Commissioner, TC
Memo 1999-129, TC Memo 1999-129 )
Valuation -- Dissolved Partnership -- Lack of Control, Marketability and Liquidation Costs Discounts.
Estate tax refund was denied where estate undervalued decedent's 25%
assignee interest in dissolved family partnership: IRS correctly determined
that only selling expense discount applied. 5.4% liquidation costs discount was
appropriate where hypothetical buyer would decrease offering price to account
for charge to repay costs of selling assets; but minority interest, portfolio and
marketability discounts didn't apply where assignee interest included statutory
right to share in partnership's surplus and hypothetical buyer wouldn't adjust
price to reflect asset mix. Also, Texas law and partnership agreement
restricted potential for litigation.(Adams, et al. v. U.S., DC TX, 83
AFTR 2d 99-1887 )
Closely Held Stock -- Valuation.
IRS's estate tax valuation of controlling stock interest in family corp. was
upheld with modifications: 2 isolated sales of 3.25% and 4.67% interests by family
members who weren't knowledgeable about stock's underlying value didn't reflect
value of estate's 21.51% interest; and estate's appraiser relied on faulty
assumptions and corp. management's unverified representations, didn't explain
corp.'s similarity to comparison cos., and didn't properly account for estate's
controlling interest or corp.'s marketability. (Estate of Alice Friedlander
Kaufman v. Commissioner, TC Memo 1999-119, TC Memo 1999-119 )
Stock Valuation -- Closely Held Corps. -- Collective Voting Premium; Equity Value.
Tax Court valued decedent's 23.55% voting and 2.79% nonvoting stock
interests in family corp., based on modified IRS valuation: IRS properly
accorded voting stock collective voting premium expressed as percentage of
corp.'s equity value; and taxpayer's equity value estimate didn't properly
account for seasonal changes in corp.'s short-term debt or corp.'s holding in
other corp. Also, 3% premium was proper where voting shares had post-valuation
"swing vote" potential; 35% and 40% lack of marketability discounts
applied to voting and nonvoting shares, respectively; and disparity in voting
to nonvoting shares' values was due to corp.'s unique capital structure and
shares' skewed 1 to 1,848 ratio. (Estate of Richard R. Simplot v. Commissioner,
112 TC No. 13 )
Alternate Valuation -- Closely Held Stock -- Lack of Marketability Discount.
Tax Court determined alternate valuation date value of decedent's 81.93%
interest in closely held, unlisted stock of hazardous waste S corp., based in
part on taxpayer's estimate: IRS's valuation was rejected where IRS limited its
expert to analyzing lack of marketability without considering corp.'s
environmental liability potential; and taxpayer's expert's unadjusted value
computations under income and market methods were reasonable. Also, corp.'s
potential environmental liabilities within lack of marketability discount was
properly considered under income, but not under market, method; and 25% control
premium was reasonable. (Estate of William J. Desmond v. Commissioner,
TC Memo 1999-76, TC Memo 1999-76 )
Alternate Valuation -- Real Property -- Post-return Adjustments.
Tax Court accepted estate's post-return decreased valuation of decedent's
interest in 1 of 2 real property parcels sold within 20 months of alternate
valuation date for less than reported FMV: taxpayer's expert credibly testified
that no material changes in 1st property's market occurred between valuation
and sale dates and that return value was overstated; but taxpayer didn't prove
that 2d property's alternate valuation date value equalled its sale date value.
(Estate of William J. Desmond v. Commissioner, TC Memo 1999-76, TC Memo
1999-76 )
Stock Valuation -- Blockage Discount -- Experts.
For stock valuation for estate tax purposes, 3.3%, not 22.5%, blockage
discount applied to 2.2% block of outstanding publicly-traded common stock,
which was held by decedent's trust and didn't trade on her date of death: IRS
expert's more reliable analysis showed only minimal discount was warranted. IRS
expert properly considered relative size of trust's stock block, other blocks'
ownership, current and historical trading volumes, and co.-specific events; and
expert reasonably relied on comparative statistical tabulations, and trust's
post-death sales within 3½ months of death. (Estate of Dorothy B.
Foote v. Commissioner, TC Memo 1999-37, TC Memo 1999-037 )
Decedent's Stock Interest -- Closely Held Corps.
Tax Court determined that portion of closely-held stock from predeceased
husband that was includable in decedent's estate depended on share value
reported on husband's estate return, not on subsequent, lower appraisal value.
Appraisal understated value; and husband's will, under which decedent acquired
portion of shares not passing to son pursuant to unified credit bequest, didn't
permit different valuations for purposes of funding bequest where lesser value
jeopardized marital deduction, which will also sought to maximize. (Estate
of Helen Bolton Jameson v. Commissioner, TC Memo 1999-43, TC Memo 1999-043
)
Stock Valuation; Closely Held Corps. -- Asset Approach; Marketability Discount.
Tax Court determined date-of-death value of decedent's 98% stock interest in
predeceased husband's closely held timber co. using IRS expert's asset
valuation, as adjusted: asset valuation was proper under Rev Rul 59-60, 1959-1
CB 237, and reasonable where co. was holding co. and earnings were low relative
to asset value; but IRS expert failed to account for net present value of
built-in capital gains. Also, only 3% lack of marketability discount applied
where co.'s timberland and other assets, except building or equipment, were
marketable; nuisance discount and discount to reflect selling costs that
hypothetical purchaser might incur were unwarranted; and value fixed in stock
allocation agreement between decedent's children wasn't relevant. (Estate of
Helen Bolton Jameson v. Commissioner, TC Memo 1999-43, TC Memo 1999-043 )
Valuation -- Qualified Terminable Interest and Revocable Trust Property -- Stock -- Minority Share.
Tax Court applied 25% lack of marketability discount to date-of-death value
of decedent's minority stock interests in predeceased husband's corp. held in
QTIP trust he established and in her revocable trust. Although parties'
experts' opinions set appropriate discount range, Court generally relied on
taxpayer's experts, despite excluded contradictory information: 1 expert didn't
relate mean discounts to corp.'s financial details; and 2d expert provided 3
disposition methods, but admitted flawed analysis and failure to compare
similar transactions. And, IRS's discount was inadequate where it didn't show
that expert's private placement analysis was only method that hypothetical
buyers and sellers would consider. (Estate of Harriett R. Mellinger v.
Commissioner, 112 TC 4 )
Valuation -- Partnership Interests Passing at Death --
"Assignee" Vs. Partnership Interests. Limited partnership interests
that passed at decedent/partner's death to personal representative and
grandchild were valued as "assignee," not partnership, interests:
although limited partner status could be conferred on assignees if general
partners consented, valuation standard was objective hypothetical buyer/seller,
so subjective consent factor wasn't considered. But, general partnership
interest that passed at death was valued as partnership interest where
partnership agreement automatically treated assignee/personal representative as
general partner. (Estate of Ethel S. Nowell v. Commissioner, TC Memo
1999-15, TC Memo 1999-015 )
Decedent's Stock in Closely Held Corporation.
The Tax Court has valued a decedent's minority share of the common stock in a closely held Texas corporation, finding that the Service's expert overstated the value and applying a 40 percent discount for lack of marketability.
Ann Brookshire owned, directly and indirectly, a total of 9.8 percent of the stock of Brookshire Grocery Co., which operated retail grocery stores in rural communities in Texas, Louisiana, and Arkansas. The company's stock is not listed on any stock exchange and is not traded over the counter,and it is owned only by relatives of Wood Brookshire, current and former company employees, and an employee profit-sharing plan.
In 1988 Brookshire and the corporation entered into a stock purchase agreement providing that after her death, her estate could opt to have the corporation purchase up to $7.8 million worth of the
estate's stock; that amount represents the amount of life insurance the company carried on Brookshire's life. The company had entered similar agreements with other family members. The purpose of the agreements was to ensure that the estates would have sufficient funds to pay estate taxes relating to the stock ownership.
Judge Stephen J. Swift determined that a 40 percent discount was appropriate
given the lack of ready market for the stock, the restrictive buy-sell
agreements, the absence of prior transactions involving large blocks of stock,
and the fact that Brookshire owned a minority interest. As to the stock's base
value, Judge Swift found that the Service's expert overstated the value by
using uncomparable companies and failing to consider the recent competition from
WalMart that had seriously decreased the company's sales. Estate of Ann H.
Brookshire, Harvey B. King, Independent Executor V. Commissioner of Internal
Revenue, T.C. Memo. 1998-365.
Code Sec. 2032A
Sale of Farmland Development Rights Triggers Special Use Valuation Recapture
Farmland may be valued for estate tax purposes based on its actual use rather than its highest and best use if the property passes to one or more qualified heirs and various other requirements are met. ( Code Sec. 2032A) The benefit of special use valuation is recaptured if the qualified use stops prematurely. ( Code Sec. 2032A(c)) Reversing a district court, in a case of first impression, the Third Circuit has held that sale of farmland development rights to a state (New Jersey) under its program to preserve agricultural land was a disposition that triggered recapture.
Observation: Many states have similar programs. Thus, although this decision involved farmland located in New Jersey, it can affect recapture of special use valuation of farmland located throughout the country.
Facts. James C. Gibbs, Sr. owned and operated a dairy farm when he died in late '84. At that time, the property had a fair market value of $988,000 based on its highest and best use for development. Its value as a farm was $349,770.
James C. Gibbs, Jr. (Gibbs) was the executor and sole heir of his father's estate. In '85, he timely filed an estate tax return electing special use valuation. This resulted in tax savings of $218,328. As required under the Code, Gibbs agreed to be personally liable for any additional estate tax due (the "recapture tax") if he disposed of any interest in the property within ten years of his father's death.
On Dec. 21, '93, Gibbs and the State of New Jersey executed a "Deed of Easement." This gave New Jersey a development easement in the farmland. In return, Gibbs received over $1.4 million. The purchase was made under New Jersey's "Agriculture Retention and Development Act," which was enacted, among other reasons, to strengthen New Jersey's agricultural industry and to preserve farmland in the State.
The Deed of Easement specified that the "Grantor" of the easement was James C. Gibbs, Jr., both in his individual capacity and as executor of the estate, along with his daughter, Diane Gibbs. It stated that "The Grantor, Grantor's heirs...successors and assigns grants and conveys to the Grantee a development easement" on the farmland. The deed expressly prohibited any development of the land for nonagricultural use and provided that the restrictions would be binding on any person to whom title is transferred.
IRS determined that the sale of development rights was a disposition of an interest in the property that triggered the recapture tax. Gibbs disagreed but he paid the recapture tax and filed a claim for refund. After IRS disallowed it, he sued in district court and won.
The district court observed that under the applicable New Jersey statute, a development easement is considered an "equitable servitude" and not a true easement. The district court determined that New Jersey treats equitable servitudes as creating contract rights, not property rights. Based on this, it ruled that Gibbs did not part with a real property interest in granting the development easement to the state and that the sale of the development easement was not a disposition of any interest in the farmland under the recapture provision.
IRS argument on appeal. IRS argued that the district court erred in holding that Gibbs did not owe the recapture tax because, under New Jersey law, a development easement purportedly gives rise to contract rights as opposed to property rights. IRS said that once the district court determined that the development easement created rights that were recognized under state law, it should have turned to federal law to determine whether the transfer of those rights was a disposition of an interest triggering recapture tax.
Third Circuit agrees with IRS. The Third Circuit agreed with IRS that the district court erred in predicating its decision on the manner in which development easements are classified under New Jersey law. The Third Circuit said that New Jersey law was relevant only to the extent that it defined the development easement that Gibbs deeded to the state. The state law consequences of that definition, however, as well as the state's doctrinal classification of the development easement as an easement, restrictive covenant, equitable servitude, or anything else, have no bearing on the application of the recapture tax provision. Having determined that the development easement is recognized under state law, the district court should have turned to federal law to decide whether the transfer of the development easement constituted a disposition of an interest in farmland for recapture purposes.
Relying on well-established principles of property law and estate taxation, the Third Circuit concluded that the conveyance of the development easement was a disposition of an interest in the farm. The Court observed that the real property that passed to Gibbs on the death of his father can be viewed in two portions: (1) the "bundle of rights" relating to the agricultural use of the land and (2) the additional value represented by the "bundle of rights" relating to development uses of the land.
The Court stressed that if the special use provision did not exist, Gibbs
would have been required to pay estate taxes on the entire bundle of rights
associated with the farm. He avoided paying estate taxes on the bundle of
rights associated with the development uses of the land by electing to value
the farm under the special use provision. He did so on the understanding that
he would not realize the value of those rights within the ten year recapture
period. In executing the Deed of Easement, however, Gibbs conveyed to New
Jersey "all of the nonagricultural development rights and development
credits appurtenant to the lands and premises." In exchange for these
valuable development rights, he received over $1.4 million. Through this
transaction, Gibbs disposed of valuable property rights that the Code would
have otherwise taxed when those rights were passed from his father, but did not
because of the special use valuation election. Because the disposition occurred
within ten years of his father's death, the recapture tax was due. Est of
Gibbs v. U.S., 82 AFTR 2d 98-7421 (CA3 1998)
Valuation of Farm Property.
The 1999 interest rates to be used in computing the special use value of farm
related property for which an election is made under Code Sec. 2032A are listed
for estates of decedents. (Rev Rul 99-20 , United States Tax Reporter ¶ 144,340
)
Valuation of Farm Corp. Stock -- Availability of 30% Minority Interest Discount -- Fair Market Value.
In the absence of regulatory guidance, IRS has acquiesced in Tenth Circuit's
holding that estate could take both 30% minority interest discount and Code
Sec. 2032A election to value ltd. partnership interest in cattle ranch. IRS
concluded that proper application of Code Sec. 2032A involved determination of
FMV, and that application of minority interest discount was part of FMV
calculation. IRS noted that although provisions of Code Sec. 2032A directed
that regs be issued to address application of special use valuation to farm
property held indirectly, such as partnerships, no regs have yet to be issued,
and that Tenth Circuit's analysis wasn't an unreasonable interpretation.
(Action on Decision 98-006, 8/31/98 , United States Tax Reporter ¶ 144,310 )
No Special Refund Period for '97 Act Change to Special Use Valuation Irs Letter Ruling 9843001 Through Irs Letter Ruling 9843005
Farmland may be valued for estate tax purposes based on its actual use rather than its highest and best use if the property passes to one or more qualified heirs and various other requirements are met. ( Code Sec. 2032A) The benefit of special use valuation is recaptured if the qualified use stops prematurely. ( Code Sec. 2032A(c) ) Leasing the property for cash generally triggers recapture.
The '97 Act provided that, for purposes of the recapture tax, a surviving spouse or lineal descendant of the decedent is not treated as failing to use qualified real property in a qualified use solely because he leased the property to a family member on a net cash basis. This change, which was embodied in Code Sec. 2032A(c)(7)(E) , was made retroactively effective for leases entered into after Dec. 31, '76.
In a series of Technical Advice Memorandums apparently relating to multiple qualified heirs of the same decedent, IRS has concluded that this change does not permit a refund of recapture tax unless the claim is filed within the normal limitations period for refund claims because the '97 Act provided no special exception to the statute of limitations. Under the facts, however, some interest was refundable with interest because it was paid within 2 years of the refund claim.
Facts. An individual, whom will call Frank Smith, died in '80 owning farm property that passed, in part, to a qualified heir, whom we'll call Mary Smith. The farm was included in Frank's gross estate and the estate elected to value it under the special use valuation rule of Code Sec. 2032A .
In May '83, Mary began renting the farm property to a family member on a cash lease basis. She filed a Form 706A, Additional Estate Tax Return (the form for reporting the recapture tax), in '91 reporting the cash lease of the property. Based on the return, IRS assessed the additional estate tax (recapture tax) and interest. In May '91, Mary paid the recapture tax (which had been due in '83), and subsequently filed a claim for refund of the tax paid. IRS disallowed the claim in June '93 and, in Jan. '96, Mary paid underpayment interest of $14,143, the interest that had accrued on the delinquent tax and unpaid interest on the tax.
In Sept. '97, after the '97 Act made the retroactive change with respect to cash leases, Mary filed a claim for a refund of the recapture tax and interest paid. No waiver of limitation period. The TAM concluded that the effective date of the '97 Act change did not constitute a waiver of the limitations period for filing a claim for refund under Code Sec. 6511(a) . The TAM said that neither the legislative and administrative history, the statutory language of Code Sec. 2032A(c)(7)(E) , nor the effective date of the provision indicates a congressional intent to extend the period of limitations for filing a claim to reopen closed tax years. The TAM stressed that, in contrast, in several other situations where Congress retroactively amended Code Sec. 2032A , it specifically extended the period for filing a claim to obtain the benefit of the amendment.
Only refund of interest allowed. A claim for refund of an overpayment of tax
must be filed by the taxpayer within three years from the time the return was
filed or two years from the time the tax was paid, whichever period expires
later. ( Code Sec. 6511(a)) Under Code Sec. 6511(b)(2)(B) , if the claim was
not filed within the three-year period, the amount of credit or refund may not
exceed the portion of the tax paid during the two years immediately preceding
the filing of the claim. In this case, Mary filed the claim for refund in Sept.
'97, more than three years from the time the Form 706A was filed. During the
two years immediately preceding the filing of the claim, she paid underpayment
interest of $14,143 which, for this purpose, is treated as a payment of the tax
under Code Sec. 6601(e)(1) . Therefore, Mary filed her claim within two years
from the time the tax was paid, and the claim is timely. However, the amount of
the refund is limited to the $14,143 payment made during the two years
immediately preceding the filing of the claim. The TAM also concluded that Mary
is entitled to overpayment interest because no provision in the '97 Act
expressly prohibits the payment of interest on overpayments resulting from the
application of the retroactive change on cash leases.
Stepchildren Are Family Members under Valuation Rules for Buy-sell Agreements and Restrictions
The estate, gift and generation-transfer tax value of property generally is determined without regard to (1) any option, agreement, or other right to acquire or use the property at a price less than its fair market value (without regard to the option, agreement, or right), or (2) any restriction on the right to sell or use the property. ( Code Sec. 2703(a)) This rule doesn't apply to any right or restriction that meets these requirements:
...it is a bona fide business arrangement;
...it is not a device to transfer the property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and
...its terms are comparable to similar arrangements entered into by persons in an arm's length transaction. ( Code Sec. 2703(b))
Code Sec. 2703 doesn't define family member for purposes of the above rule and the IRS National Office was called upon to determine whether the children of an individual's predeceased spouse were family members with respect to the individual. Based on regs, the National Office concluded that these stepchildren were family members.
Facts. Under the ruling, a couple, whom we'll call John and Mary, were married. Mary, who had children from a prior marriage, died in Year 1. John died in Year 2. Under Mary's will, John received an income interest for life and a general power of appointment over certain property held in trust, which included general and limited partnership interests.
By will, John exercised the power of appointment over certain property he received in trust from Mary in favor of particular persons, including Mary's children (John's stepchildren). This property included the general and limited partnership interests. Under the terms of the partnership agreement, restrictions were placed on the transfer of these interests.
Stepchildren were family members. Reg § 25.2703-1(b)(3) provides that, for purposes of Code Sec. 2703, members of the transferor's family include the persons described in Reg § 25.2701-2(b)(5) and any other individual who is a natural object of the transferor's bounty. The persons described in that reg include any lineal descendants of the parents of the transferor or the transferor's spouse. In this case, John is the transferor. Thus, the TAM concluded that his step-children, who are lineal descendants of his spouse, are members of his family for purposes of the Code Sec. 2703 rules.
Observation: In reaching this conclusion, the TAM made no mention of
the fact that Mary was no longer John's spouse at the time of his death because
Mary was no longer living. In effect, the TAM read the reg as though it reached
lineal descendants of a former spouse. Whether the TAM would have reached a
similar conclusion had John been remarried at the time of his death or with respect
to divorced spouses is not clear. IRS Letter Ruling 9841005
IRS Acquiesce in Decisions on Minority Discount and Tax Protest
IRS Chief Counsel has recommended that IRS acquiesce in the following court decisions adverse to its previous positions:
Special use valuation and minority discount. The Tax Court has held that where an estate elects special use valuation for stock in a family corporation that owns farmland, it cannot further reduce the special use value to reflect a minority discount. (Maddox, Frances Est, (1989) 93 TC 228; Hoover, Clara Est, (1994) 102 TC 777) While agreeing with the Tax Court that a minority discount and special use valuation aren't both available where the special use estate tax value of property is decreased by less than the maximum $750,000 reduction permitted by Code Sec. 2032A(a)(2), the Tenth Circuit reversed the Tax Court in Hoover and held that an estate that elected to value ranch property (held through a trust as a 26% limited partnership interest) at its special use value could also apply a minority discount to arrive at the fair market value of the property for purposes of determining the amount from which the $750,000 maximum reduction in value is subtracted. (Hoover, Clara Est v. Com., (1995, CA10) 76 AFTR 2d 95-7305, 69 F3d 1044, revg (1994) 102 TC 777)
Code Sec. 2032A(g) specifies that IRS will issue regs setting forth the application of special use valuation to interests held indirectly through partnerships, corporations or trusts, but IRS hasn't issued those regulations. In the absence of regulations, IRS will not litigate the issue of whether a valuation discount is available where the Code Sec. 2032A(a)(2), $750,000 maximum valuation reduction limit applies. (CC-1998-006)
Return signed "under protest." McCormick signed his Form 1040 under the jurat (the language immediately before the signature lines declaring that the return is signed under penalties of perjury) and wrote "under protest" beneath his signature. Because of this statement, IRS did not consider the filed document to be a return and assessed a penalty under Code Sec. 6702 for filing a frivolous return. A district court held, however, that the words "under protest" did not alter the meaning of the jurat. It found that McCormick had properly exercised his First Amendment right to protest to IRS while still complying with his obligation file. (McCormick, Lawrence v. Shirley Peterson, (1993, DC NY) 73 AFTR 2d 94-597, 94-1 USTC ¶50026)
IRS now agrees with McCormick. It says that in order to render a document
frivolous, a taxpayer's added statements must reasonably cast doubt on the
validity of the jurat and be more than a mere expression of grievance. A
taxpayer who adds the words "under protest," without modifying the
words of the jurat, does not cast doubt on the validity of the jurat and,
accordingly, does not invalidate the document as a return. (CC-1998-005,
CC-1998-006)
Code Sec. 2033
Gross Estate -- Decedent's Interest in Real Property -- Resulting Trust -- Proof.
100% of value of decedent's residence was includable in her estate: estate
didn't establish resulting trust in 20-year companion's favor for ½
of residence at time of purchase under Illinois law. No agreement regarding
companion's consideration existed: testimony showed decedent wasn't concerned
about companion's contribution of sufficient services; value of services was
repayment for living expenses and rent, not ½ of residence's
purchase costs; title to 2d property was held jointly and later put solely in
companion's name; decedent took 2d mortgage without companion's approval; and
companion's assertion in Illinois probate court, which approved
tenancy-in-common without reaching merits, conflicted with downpayment
testimony in this case. (Estate of Lucille M. Horstmeier v. Commissioner,
TC Memo 1999-145, TC Memo 1999-145 )
Bequests -- Administrative Costs -- Will Interpretation.
Amount includable in decedent's gross estate as bequest of ½ of
predeceased mother's gross estate included ½ of her estate
administration costs: including costs didn't violate mother's express intent
that bequest not be diminished by federal estate taxes where will directed that
federal taxes and administrative costs be paid out of residuary estate, and
decedent's share was specific bequest, not part of residue. Also, will didn't
express any intent not to use "gross estate" in technical sense; and
specific language limiting administrative costs allocation wasn't necessary
under North Carolina law. (Estate of Harry Fagan Jr. v. Commissioner, TC
Memo 1999-46, TC Memo 1999-046 )
Aggregation of Stock Interests -- Qualified Terminable Interest and Revocable Trust Property -- Valuation.
For valuation purposes, decedent's minority stock interests in predeceased
husband's corp. held in QTIP trust he established weren't aggregated with same
stock held in her revocable trust, even though all stock was includable in her
gross estate. Code Sec. 2044 and legislative history didn't require aggregation
of fractional interests of same property included in estate under Code Sec.
2033, didn't require that decedent be treated as QTIP's owner, and didn't
mandate identical tax consequences as outright transfer to surviving spouse;
decedent didn't have control or disposition power over QTIP; and absence of
valuation language showed Congress didn't intend special valuation rule to
apply to property included in estate under Code Sec. 2044. (Estate of
Harriett R. Mellinger v. Commissioner, 112 TC 4 )
SEC Restrictions Reduce Estate Tax Value of Shares Even Though Restrictions Lapse at Death
Reversing the Tax Court, a divided Ninth Circuit panel has held that SEC restrictions that limited the value of shares held by a decedent are taken into account in determining their estate tax value, even though the restrictions lapsed once the shares were in the hands of the decedent's estate.
Facts. Charles K. McClatchy died in '89, owning over 2 million class B shares of McClatchy Newspapers, Inc. (the Company). The nonpublicly traded shares were valued on his estate tax return at about $12.34 per share. At the time of his death, McClatchy was the Company's CEO and chairman of its board of directors.
McClatchy was an Affiliate of the Company for federal securities law purposes because he was CEO and a director, a class B shareholder, and had beneficial ownership of class B shares as trustee and beneficiary of trusts holding class B stock. The class B stock owned by McClatchy before his death was unregistered and restricted for federal securities law purposes under SEC Rule 144. As a result, the shares could only have been sold by McClatchy to the public in accordance with certain volume and manner-of-sale restrictions and any donee or transferee would have acquired the shares subject to the restrictions.
McClatchy's executors, acting in that capacity, were not collectively an Affiliate for federal securities laws purposes and, therefore, were not subject to the same securities law restrictions applicable to McClatchy. Nor was the estate an Affiliate. Thus, the restrictions that limited the stock's value during McClatchy's life did not limit their value in the hands of his estate.
Valuation dispute. IRS agreed that the fair market value of the restricted shares for estate tax purposes would have been about $12.34 per share. However, it argued that the restrictions could not be taken into account in valuing them. The parties agreed that if IRS's view were correct, the stock had an estate tax value of $15.56 per share.
The estate argued that the class B shares subject to securities law restrictions comprised the "interest" in property under Code Sec. 2033 that was transferred by McClatchy at death, that the value of such interest is all that is included in the estate, and that the value of the interest transferred by him is determined by valuing only his restricted share interest. Further, the estate argued that if valuation under Code Sec. 2031 were at issue, the proper measure of value would be limited to that which McClatchy could have realized during his lifetime, because the securities law restrictions were not self-imposed and the facts did not present an abuse situation.
IRS argued that the securities law restrictions lapsed at McClatchy's death and should not be considered in valuing the shares at the moment of death because the value of the shares for estate tax purposes must take into account any changes brought by death. IRS further contended that legislative history does not support the proposition that the unified transfer tax system requires that pre-death restrictions be taken into account in determining estate tax value.
Tax Court agreed with IRS. The Tax Court held that the interest passing from McClatchy was the value of the shares unaffected by the securities law restrictions, i.e., $15.56 per share. It said that the change in the shares' value was caused by death because at the instant of death the securities law restrictions no longer applied. The restricted value of the shares while McClatchy was living did not control the value transferred. It also agreed with IRS that there is nothing in the legislative history of the unified transfer tax system to suggest that Congress intended to ignore changes in the value of property brought about by death.
Ninth Circuit reverses Tax Court. The Ninth Circuit majority held that the stock should be valued in the hands of the decedent, as reduced to reflect the restrictions. It agreed that where death clearly is the precipitating event and is the only event required to fix the value of property, changes that take place at death are considered in fixing affected property's estate tax value. However, in this case the Ninth Circuit majority found that death alone did not cause the increase in the value of McClatchy's stock. Rather, it held that the value of the stock was transformed only because the estate was a Non-affiliate. Had it been an Affiliate, the securities law restrictions still would have applied. The Affiliate or Non-affiliate status of an estate depends on the status of the executor; the court said that since the executor of McClatchy's estate was not appointed until 25 days after McClatchy's death, the restrictions did not evaporate at the moment of his death. It opined that making the amount of estate tax dependent on the Affiliate or Non-affiliate status of the estate's executor contradicts the principle that valuation should not depend on the status of the recipient.
Dissent. One of the three Ninth Circuit judges dissented, expressing the view that the Tax Court properly valued McClatchy's stock as it existed in the hands of his estate, rather than as it existed in his own hands. The dissent found that McClatchy's death altered the value of his property by causing the shares to be passed to his Non-affiliate estate, thereby voiding the restrictions that had previously attached on account of his Affiliate status. Since the lapse went into effect before distribution of the shares by the estate, the dissent argued that it must be considered in determining their estate tax value.
Observation: It remains to be seen whether other circuits will adopt the position of the Ninth Circuit or that of the Tax Court on this issue. Taxpayers who are Affiliates with substantial amounts of restricted stock may avoid the possibility of having the shares valued without regard to the restrictions by naming other Affiliates as their executors. That way the stock would continue to be subject to SEC restrictions while in their estates.
Observation: Where the Tax Court position might apply and SEC restrictions
would continue after a lifetime stock transfer, the tax on gifted restricted
shares might be lower than the estate tax on unrestricted shares transferred at
death. Thus, owners of transferable restricted stock may want to consider
making lifetime gifts of such shares. However, any expected transfer tax
savings would have to be weighed against potentially greater income tax
liability on the beneficiary that could result from the carryover basis
applicable to gifted property as opposed to the stepped-up basis that applies
to property received from a decedent. Also, the impact of the anti-freeze rules
of Code Sec. 2701, Code Sec. 2702, Code Sec. 2703, Code Sec. 2704 should be
considered before making lifetime transfers of closely held stock interests to
family members.
Fair market value deduction for contributions of qualified appreciated stock
to private foundations retroactively restored and made permanent
The deduction for contributions of appreciated property to a private
foundation is generally limited to the adjusted basis of the property, rather
than the full fair market value of the property. An exception, allowing a
deduction equal to the full fair market value, applied for contributions of
qualified appreciated stock (stock which is traded on an established securities
market) to private foundations made before July 1, '98.
Effective retroactively for contributions after June 30, '98, the Extension
Act makes the exception for contributions of qualified appreciated stock to
private foundations permanent. (Act §1004(a); Code Sec. 170(e)(5))
Observation: Taxpayers can now plan to make contributions of
qualified appreciated stock in tax years in which the greatest tax benefit will
be realized. They no longer need to be concerned about timing their
contributions to take into account expiration of the special rule when it
applied for limited periods.
Transfer from one spouse's IRA to the other spouse's IRA is a taxable
distribution.
The transfer by a taxpayer of a portion of his IRA maintained with one
trustee to his spouse's IRA maintained with another trustee was treated as a
distribution includible in the taxpayer's gross income under Code Sec.
408(d)(1). The provision taxing distributions from an IRA is not overridden by
Code Sec. 1041(a), which provides that no gain or loss is recognized on the
transfer of property between spouses. When Code Sec. 1041(a) was enacted it did
not change Code Sec. 408(d)(1). (IRS Letter Ruling 9422060; IRS Letter Ruling
8820086) Est of McClatchy v. Comm., (6/26/98, CA9) 81 AFTR 2d 98-5001
Code Sec. 2036
Grantor Retained Income Trust -- Release of Reversionary Interest - Retroactive Statutory Appeal.
District court properly granted grantor refund of gift taxes she paid on
releases of contingent reversionary interests in GRIT: releases, which were
executed to avoid payment of greater gift taxes under Code Sec. 2036(c) before
it was retroactively repealed nunc pro tunc, were rescindable under
Pennsylvania law where grantor acted under unilateral mistake as to effect Code
Sec. 2036(c) would have on her tax liabilities. (Neal v. U.S., CA 3, 83
AFTR 2d 99-2325 )
Valuation of Closely-held Corp. Stock -- Built-in Gains Tax Discount.
Real property including vacation residence and rental apartment that
taxpayer/trustee proposes to transfer to irrevocable trust qualifies as
personal residence under Reg § 25.2702-5(c)(2): apartment's rental is
incidental to property's use as residence under Reg § 25.2702-5(c)(2)(C)(iii) ;
and property otherwise satisfies reg.'s requirements. Also, trust meets Reg §
25.2702-5(c)'s qualified personal residence trust requirements where it
contains requisite incorporated provisions. And, in absence of agreement
regarding taxpayer's continued use of property after trust's income term
expires, property transferred to trust, which will pass to family trust for
spouse's lifetime benefit if spouse is living and still married to taxpayer
after term expires, and pass in trust for taxpayer's descendants' benefit upon
spouse's death, will not be includible in taxpayer's gross estate if taxpayer
survives such term: under Rev Rul 70-155, 1970-1 CB 189, taxpayer's
co-occupancy with spouse didn't support inference of agreement or understanding
as to taxpayer's retained possession or enjoyment. (IRS Letter Ruling 199906014
, United States Tax Reporter ¶ 144,332 )
Court Allows Refund of Gift Tax Paid on Gift That Was Later Rescinded
In a case involving former Code Sec. 2036(c), which was added to curb estate freezing transactions, such as recapitalizations, and later retroactively repealed in favor of the special valuation rules in Code Sec. 2701 through Code Sec. 2704, the Third Circuit, in an unpublished opinion, has allowed a refund of gift taxes paid by an individual who made a gift of her contingent retained reversion so that she wouldn't be snared by that former Code section, and later rescinded the gift after the retroactive repeal.
Facts. In '88, Kathryn Neal, a Pennsylvania resident, created a grantor retained income trust (GRIT) to last for a set number of years. The income was payable to Neal for the term of the trust and she also retained a contingent reversionary interest in the trust corpus itself in the event she died before the end of the trust term. Neal paid gift taxes when she created the trust. The gift was equal to the value of the property transferred to the trust less the value of her retained income interest and her retained contingent reversion.
Observation: Under the rules that then existed (and under current law), if a grantor of a GRIT died before the trust term, the property would be brought back into his estate even though the remainder would go to the person originally named as donee when the GRIT was set up. Retaining a contingent reversion had two benefits: (1) it lowered the cost of the gift of the remainder, and (2) if the grantor died before the end of the term, the grantor would be in a position to transfer the property to his spouse and use the marital deduction to shield it from estate tax. Under the current rules, an individual who sets up a GRIT for a family member generally is treated as making a gift of 100% of the property placed in the trust unless the retained interest is a qualified annuity interest or unitrust interest or the trust property is the grantor's residence. As was the case before, under current law, death before the end of the term, even where a qualified interest is retained or the trust is a residence GRIT, brings the property back into the estate under Code Sec. 2036.
After Neal set up the GRIT, IRS issued Notice 89-99, 1989-2 CB 422, to explain the reach of former Code Sec. 2036(c) which was enacted in '87 to curb estate "freezes." In '88, Congress created an exception under former Code Sec. 2036(c) for a retained "qualified trust income interest."
Notice 89-99, 1989-2 CB 422, concluded that contingent reversionary interests, such as the one held by Neal, did not qualify for the exception. However, the notice allowed affected taxpayers to benefit from the exception if they released enough of their contingent reversionary interest before Jan. 1, '90, so that any remaining reversionary interest was below a certain threshold. In response to the Notice, in late '89, Neal released all of her contingent reversionary interest in the GRIT in order to avoid the tax liability that would have resulted under former Code Sec. 2036(c), as construed by the Notice. The release gave rise to further taxable gifts, and Neal paid gift taxes on them.
In '90, Congress repealed Code Sec. 2036(c), retroactive to the date of its enactment. As a result, Neal's release of her contingent reversionary interest was no longer beneficial to her. She then executed a document rescinding the releases, and requested a refund of the gift taxes paid on them. The state court with jurisdiction over the trust allowed the rescission after concluding that Neal released her contingent reversion in the mistaken belief in the validity of Code Sec. 2036(c) and the Notice.
After the state court allowed the rescission, Neal filed a claim with IRS for a refund of the gift taxes paid on the gifts of the retained reversions. IRS denied the claim. Neal went to district court and won. IRS appealed to the Third Circuit and Neal won again.
Third Circuit's reasoning. The Third Circuit pointed out that IRS conceded that a gift may be incomplete and therefore non-taxable if it may be rescinded under state law. However, IRS said that the gifts were not rescindable. The Third Circuit disagreed. It said that, for all practical purposes, the retroactive repeal of Code Sec. 2036(c) made the law at the time Neal released her reversionary interests other than what she understood it to be. A transfer based upon a mistake of law is rescindable under Pennsylvania law, and therefore incomplete for tax purposes. The Third Circuit pointed out that the district court recognized that IRS would be quick to assert a claim if the tax laws were changed retroactively to indicate that Neal owed a higher tax.
While Neal was under no mistake as to the status of the law at that moment, she was mistaken as to the effect that the law would have on her tax liabilities. The general doctrine of mistake is geared toward freeing persons who were mistaken regarding the effect that a particular law would have on their situation. As a result, the district court and the state court properly found that Neal released her interest "under a mistake of law."
IRS's position was essentially that Neal was under no mistake of law when
she released her reversionary interests in the GRIT and that the effects of the
retroactive repeal of Code Sec. 2036(c) should not be considered. However, the
Third Circuit disagreed and held that Neal's releases were rescindable under
state law and that the district court properly held that she was due a refund
of the '89 gift tax that she paid on the releases.Neal v. U.S., (CA3
4/12/99) 83 AFTR 2d 99-778
Code Sec. 2038
Estate Taxes -- Aggregation of Partnership Interests -- Qualified Terminable Interest and Revocable Trust Property.
For valuation purposes, decedent's partnership interests held in QTIP trust
weren't required to be aggregated with interests held in revocable trust, even
though interests were includable in decedent's gross estate under Code Sec.
2044 and Code Sec. 2038: Tax Court declined to depart from Mellinger, Harriet
Est, (1999) 112 TC 4, and determined that Code Sec. 2044 and its regs didn't
show that Congress intended aggregation of interests for valuation purposes, or
that decedent should be treated as owner of QTIP for aggregation purposes. (Estate
of Ethel S. Nowell v. Commissioner, TC Memo 1999-15, TC Memo 1999-015.
Section 2044
Property Interests Held by Two Trusts Aren't Merged for Valuation.
The Tax Court has held that a decedent's property interests held by a survivor's trust should not be aggregated with property interests held by a qualified terminaable interest property (QTIP) marital trust for valuation purposes. Ambrosina Lopes had undivided interests in several real properties. The property interests were held in a survivor's trust and a QTIP marital trust, which were created by Ambrosina and her now- deceased husband Joaquim. When Joaquim died in 1990, the IRS allowed a marital deduction under section 2056(b)(7) for the value of his estate passing into the QTIP trust. After Joaquim's death, Ambrosina transferred some of her property interests held in the survivor's trust to her son. Ambrosina died in 1993.
Citing Estate of Mellinger v. Commissioner, 122 T.C. 26 (1999) (1999 TNT
17-6, Doc 1999-3887 (34 original pages)), Judge Joel Gerber held that
Ambrosina's property interests held in the two trusts should not be aggregated
for the purpose of determining the fair market value of the property passing from
her estate. Judge Gerber noted that neither section 2044 nor the legislative
history indicates a congressional intent that property passing through a
decedent's estate under section 2044(c) be treated as if the decedent actually
owned that property for aggregation purposes. Thus, Ambrosina's fractional
property interests in the two trusts should be valued separately. Estate of
Ambrosina Blanche Lopes, Deceased, James W. Lopes, Trustee, V. Commissioner of
Internal Revenue, T.C. Memo. 1999-225.
Code Sec. 2053
claims against estate; income tax liability -- postdeath adjustments.
Estate's deduction for decedent's year-of-death federal income tax liability
was reduced by postdeath refund of that tax: income tax liability, which
related to value of stock passed through from predeceased husband's estate, was
open to challenge and wasn't "sum certain" at death, so postdeath
events were relevant; and approved refund was no longer enforceable claim
against estate. And, deduction for state income taxes was similarly reduced to
reflect decedent's corrected state liability, even though estate hadn't amended
state return or claimed state refund: unexplained failure to file protective
state refund claim didn't preclude determination of claim amount. (Estate of
Evelyn M. McMorris v. Commissioner, TC Memo 1999-82, TC Memo 1999-82 )
Code Sec. 2053
Estate Tax Refund Claims -- Settlement Payments -- Deductions; Claims
Against Estate. District court properly denied estate's refund claim. Payment
to settle decedent's descendants' tort claims for trustee's interference with
inheritance wasn't deductible claim against estate where trustee's alleged tort
wasn't decedent's personal obligation at death: claims were based on
descendants' potential heir status; facts that amounts were distributed after
threatened tort litigation, testamentary instruments weren't challenged, and
decedent intended different estate disposition were irrelevant; and tort
liability would have been trustee's, not estate's. Also, payment wasn't
deductible as administrative expense where it wasn't actually prepayment of
attorney's fees or charitable contribution merely because substantial
litigation costs were avoided. (Lindberg v. U.S., CA 10, 83 AFTR 2d
99-444 )
Administrative Expense Deduction -- Maintenance and Sale of Decedent's Residence.
On 2d remand, estate was denied Code Sec. 2053 deduction for post-return
filing costs it incurred to maintain and sell mansion held in marital trust
established by decedent's pre-deceased husband. Expenses weren't
"necessary" to estate's administration under Reg § 20.2053-3 where
trust had sufficient liquid assets to pay its potential tax liability and sale
primarily benefited residuary trust beneficiaries: marital trust could have
kept interest and dividend income as tax reserve instead of distributing such
to residuary trust; and had little potential for incurring added taxes where
mansion's FMV was less than reported and estate taxes were overpaid. (Estate
of Marguerite S. Millikin, et al. v. Commissioner, TC Memo 1998-456, TC
Memo 1998-456 )
Code Sec. 2055
Charitable Deductions -- Testamentary Trusts; Charitable Purposes -- Issue Preclusion.
IRS properly disallowed estate tax charitable deduction for alleged
charitable trust bequest: state court reformation decisions, to which U.S.
wasn't party, that construed will as having created charitable testamentary
trust weren't retroactively applicable for federal tax purposes; and trust
didn't comply with Code Sec. 2055 where grant to "missionaries preaching
the Gospel of Christ" didn't refer to specific church, but unspecified
class of beneficiaries, and didn't restrict trustees' discretion. Also, merely
describing trust as charitable wasn't sufficient under Code Sec. 2055 ; and beneficiaries
had no way to enforce their rights in event of distribution to hypothetical
missionary. (Estate of Starkey v. U.S., DC IN, 83 AFTR 2d 99-2572 )
Estate Tax Refunds -- Marital Deduction; Charitable Deduction -- Summary Judgment
. Estate was denied refund reflecting disallowed marital and charitable deductions on summary judgment: estate's conclusory challenges didn't rebut IRS's determination that marital bequest of 1/3 of "my estate" referred to probate estate, not gross estate; and charitable deduction wasn't allowable under Code Sec. 2055 . (Estate of Starkey v. U.S., DC IN, 83 AFTR 2d 99-2572 )
Charitable Bequests -- Federal Estate and State Inheritance Taxes.
Decedent's charitable bequest deduction was reduced by federal estate and
North Carolina inheritance taxes: since will clearly instructed for payment of
such taxes from residuary estate, without apportionment, neither North Carolina
apportionment law nor Code Sec. 2206 applied; and apportionment under residuary
beneficiary trust agreement was irrelevant. (Estate of Harry Fagan Jr. v.
Commissioner, TC Memo 1999-46, TC Memo 1999-046 )
Estate Tax Charitable Deduction Allowed For Charitable Lead Trusts
The Service has ruled that a trust grantor may take an estate tax charitable
deduction for the value of a guaranteed annuity interest and a unitrust
interest qualifying under section 2522. An individual wants to create a will
under which the residue passes to a revocable inter vivos trust. After the
individual's death, portions of the trust will be distributed to CLATs and
CLUTs. The Service concluded that the estate could take a charitable deduction
on the date-of-death present value of guaranteed annuity and unitrust
interests. The Service also determined that the CLATs and CLUTs could take an
income tax deduction for the amounts actually paid to charities. Further, the
Service concluded that each bequest to a CLAT or CLUT would be recognized as a
separate share for generation- skipping transfer tax purposes, permitting the individual's
remaining GSTT exemption to be allocated separately to each of the CLUTs. LTR
199927031
Code Sec. 2056
Marital deduction -- qualified terminable interest property -- trustee's discretion
District court improperly upheld IRS's disallowance of portion of marital
deduction on summary judgment: IRS's determination that no probate residue was
available for addition to marital trust/QTIP trust since will directed
co-executors to pay death taxes from probate estate ignored will's alternate
provision giving trustees discretion to pay taxes from trust estate. And IRS's
argument that probate estate value was fixed at date-of-death was rejected:
trustee's discretion didn't prevent property from passing to trust and wasn't
prohibited power of appointment. (Patterson v. U.S., CA 8, 83 AFTR 2d
99-2475 )
Section 2056(b)(7)
Full Marital Deduction for Qtip, Rejects IRS's Reduction for Death Taxes.
The Eighth Circuit has reversed a district court's decision that estate executors were required to pay death taxes from the probate estate, finding instead that the decedent's will clearly gave the trustee discretion to pay those taxes from the trust estate. Robert Patterson's will directed the executor "to pay out of the residue of [the] estate any and all . . . death taxes." It also stated that if there was a trust in existence at his death, any part or all of those taxes may, in the trustee's discretion, be paid from the trust's assets.
Patterson also executed a trust agreement that created a marital trust. The trustee was to set aside 10 percent of the trust remainder, computed before the reduction for death taxes. The trust agreement
also provided that the trustee may, in the beneficiaries' best interest, pay death taxes from the trust estate.
Patterson's estate paid $4.6 million in federal death taxes from the trust estate. The estate tax return reported the value of assets passing to the marital trust as $629,500, or 10 percent of the value
of the remaining trust estate as increased by the probate residue before reduction for death taxes.
The co-executors elected to treat the full value of the marital trust as QTIP, and claimed a deduction under section 2056(b)(7). The IRS disallowed $74,000 of the marital deduction, asserting that taxes had to be paid from the probate estate. Because the death taxes exceeded the value of the probate estate, the IRS determined, there was no probate residue to be added to the trust. The estate paid the deficiency and sought a refund. The district court granted the government summary judgment, finding that the will unambiguously directed that taxes be paid from the probate estate.
Senior Circuit Judge Donald R. Ross found that Patterson's will unambiguously gave the trustee the discretion to pay death taxes from the trust estate, a finding conceded by the government in its brief. The government argued, nevertheless, that the trustee's discretion to pay taxes from the trust estate was irrelevant as a matter of law. Relying on Jackson v. United States, 376 U.S. 503 (1964) (94 TNT 241-75), the government contended that because the value of the probate estate must be fixed as of the date of the decedent's death, the trustee's post-mortem exercise of discretion cannot affect the probate estate's value.
The appeals court disagreed, finding Jackson distinguishable. In Jackson, the Supreme Court held that a widow's state-law allowance could not be part of the marital deduction because it had not yet
vested as of the date of her husband's death and was a terminable interest.
Judge Ross pointed out that when Jackson was decided, Congress had not yet
enacted the QTIP provisions, which allow marital deductions for qualifying
terminable interests. Here, the government stipulated that the marital trust
was a QTIP trust .Carol S. Patterson; Commerce Bank, N.a., as Co-executors
for the Estate of Robert M. Patterson V. United States of America, 83
AFTR2d Par. 99-818( CA8 1999).
No Apportionment' Language: Marital Portion of Residue Must Pay Share of Estate Tax.
The Tax Court has sustained the Service's determination that a surviving spouse's portion of the decedent's residuary estate must bear a proportionate share of estate tax, thus reducing the marital
deduction.
Betty Miller, a Texas resident, died in 1993. In her will she bequeathed half of her residuary estate to her husband and half to a trust. The will directed that all estate taxes be "borne by my residuary estate . . . without apportionment." The trust instrument permitted the trustee to pay estate taxes.
Miller's estate tax return apportioned all federal estate taxes to the nonmarital portion of the residuary estate. The IRS determined an estate tax deficiency, asserting that a portion of the estate
taxes had to be applied to the marital share, thereby reducing the section 2056 deduction.
Chief Judge Mary Ann Cohen found that under Texas probate law, estate tax must be apportioned among beneficiaries according to the taxable value of their interests, unless the decedent's will
specifies otherwise. Judge Cohen found that Miller "opted out" of the Texas statute because her will directed "that estate tax be paid out of the residuary 'without apportionment'." By specifying no apportionment within the residuary, Judge Cohen explained, Miller "expressed an intention that there be no discrimination between marital and nonmarital residual beneficiaries." The court cited Estate of Fine v. Commissioner, 90 T.C. 1068 (1988)(88 TNT 110-9), which construed a similar, Virginia apportionment statute.
The estate argued that Miller could not have opted out of the Texas statute because the statute was enacted after Miller executed her will. But Judge Cohen maintained that the direction in Miller's
will "manifests an unequivocal intent that there be no apportionment.
Thus, the language of the will compels this result." The estate also
contended that the trust instrument indicates Miller's intent to have estate
tax paid solely by the trust, but Judge Cohen disagreed. Estate of Betty
Pace Miller, Deceased, Jerry D. Walker, Independent Executor, V. Commissioner
of Internal Revenue, T.C. Memo. 1998-416.
Section 2503
Decedent Transferred Fractional Interests in Residence, Despite Error in Deed.
The Tax Court has held that a decedent transferred fractional interests in her life estate in her residence to her children in each of the years 1984-86, that 12 annual gifts of $10,000 in each of the
years 1985-88 were transfers of present interests that qualified for exclusion, and that 12 checks she wrote just days before her death were neither completed gifts nor claims against the estate.
Carolyn Holland's mother devised to Holland a life estate in residential property. In 1984 Holland decided to give interests in her residence to her three children in order to take advantage of the annual gift exclusion. She intended to give a one-ninth interest to each child in each of the years 1984-86, although she had misread her mother's will, believed she owned a fee simple interest, and believed
she could convey one-ninth interests in the fee simple.
Due to a scrivener's error, the deed transferred Holland's entire interest to her children in 1984. Her children did not discover the error and recorded the deed. Holland executed deeds again in 1985 and 1986, purporting to transfer additional one-ninth interests in those years.
In 1987 the parties that owned the residence attempted to sell the property. The purchaser discovered that Holland's children could convey no more than a life interest. The children quickly transferred their interests to a trust created by Holland's mother to permit Holland to sell the property in fee simple; after the children's transfer, Holland paid them $90,000.
The IRS determined that Holland made an unreported gift to her children of her entire interest in the property in 1984. During the Tax Court proceeding, the Service argued in the alternative that the
1984 transfer was void and that Holland made an unreported taxable gift of $90,000 in a "later year."
Judge Carolyn Miller Parr agreed with the estate that Holland transferred only one-ninth of her interest in the residence to each child in 1984. The court reasoned that Holland and her children intended the gifts to be of one-ninth interests, that the deed was not void because of the error, and that under state law Holland had the right to reform the conveyance. The court also rejected the Service's contention that Holland's transfer of $90,000 was gratuitous, finding that Holland purchased the interests her children had held and transferred to the trust.
On the second issue, Holland borrowed $120,000 in each of the years 1985-88 to make $10,000 annual gifts to 12 donees, including her three children. Each loan was unsecured, but her agent guaranteed the note; the loan proceeds were then used to purchase a certificate of deposit (CD) for the donees. The donees agreed to pool their funds to buy a single $120,000 CD in order to obtain a more favorable rate of interest.
Judge Parr rejected the Service's determination that the annual transfers were nondeductible gifts of future interests. However, the court found that because of the property interests Holland also
transferred to her children in 1985 and 1986, Holland's estate could not exclude the gifts to the extent the value of the one-ninth interest in her life estate plus the $10,000 cash transferred to each child exceeded $10,000 for those years.
Next, in November 1989 Holland wrote 12 checks for $10,000 each that she intended to be gifts to her children and grandchildren. She gave them to her son Jack to hold until he could arrange for a loan to cover the gifts. Before the loan could be arranged, Holland was killed in a car accident. After her death, Jack replaced those 12 checks with checks drawn on the estate's account and delivered the replacement checks to the donees. The IRS determined that the transfer of Holland's 12 checks was never completed and, thus that the $120,000 was includable in Holland's estate.
The court agreed with the IRS that the gifts were not completed under state law, finding that the gifts were not delivered. Judge Parr rejected the estate's alternative contention that the checks represented debts of the estate that were deductible expenses under section 2053.
On other issues, the court held that Holland was not personally obligated to repay $100,000 she received from a trust; thus, that amount was not excludable from her estate under section 2053. And,
Judge Parr ruled that the estate was not entitled to deduct as an administration expense the cost of a maid who maintains personal property in a condominium Holland owned with her sister, finding that
the estate failed to prove that it would have been impossible to distribute
Holland's interest in the condominium. Estate of Carolyn W. Holland,
Deceased, Jack K. Holland, Lewis G. Holland, Sr., And Betty H. Kann, Executors,
V. Commissioner of Internal Revenue, T.C. Memo. 1997-302,..
Code Sec. 2511
Gift Taxes -- Qtip Trust; Transfer of Remainder -- Adequate Consideration.
Taxpayer/son's consent to termination and distribution of QTIP trust to
mother/surviving spouse was taxable transfer of taxpayer's remainder interest
in trust: transaction resulted in transfer of valuable property interest that
depleted taxpayer's potential taxable estate for less than adequate
consideration. Also, Rev Rul 98-8, 1998-7 IRB 24, didn't require zero value on
remainder interest in QTIP trust when received by surviving spouse; and fact
that transfer didn't increase mother's potential taxable estate was irrelevant.
(IRS Letter Ruling 199908033 , United States Tax Reporter ¶ 144,333 )
Section 2512
May Not Ignore Rev. Rul. On Which Decedent Relied in Valuing Remainder Interest.
The Fifth Circuit has reversed the Tax Court in holding that a decedent was not sufficiently close to death in March 1986 to require him to depart from the Service's actuarial tables in valuing a remainder interest and related annuity.
Gordon McLendon was diagnosed with esophageal cancer in May 1985. He received radiation treatments and his condition improved, but the cancer recurred in September and was categorized as
"systemic," the most dire type of cancer. Nevertheless, McLendon began chemotherapy in October 1985. His doctor gave him a favorable report on December 3, but McLendon attempted suicide on December 5. After additional chemotherapy treatments, one doctor wrote in February 1986 that McLendon's cancer was in complete remission.
On March 5, McLendon entered into a private annuity agreement with his son and a trust established for the benefit of his daughters. He transferred a remainder interest in certain partnerships to his son and the trust in exchange for $250,000 plus an annuity to be paid to him for life. In valuing the annuity and the remainder interest, the parties to the agreement referred to the actuarial tables contained in reg. section 25.2512-5(f).
McLendon completed his last course of chemotherapy in late March. The cancer had reappeared by May, and McLendon died in September 1986.
The IRS determined that McLendon received less than adequate consideration for the remainder interest and determined gift tax deficiencies against his estate. The Tax Court agreed with the IRS
that McLendon's life expectancy was sufficiently predictable on March 5,
1986, so that use of the actuarial tables was improper. The Fifth Circuit
remanded, finding that the Tax Court inadequately explained its ruling on that
issue in light of Rev. Rul. 80-80, 1980-1 C.B. 194. The Tax Court again
sustained the Service's determination.
Circuit Judge E. Grady Jolly agreed with the estate that McLendon was entitled to rely on the actuarial tables and Rev. Rul. 80-80. Citing Miami Beach First Nat'l Bank v. United States, 443 F.2d
116 (5th Cir. 1971), Judge Jolly pointed out that the actuarial tables reflect the estimated life interests of persons of all health, justifying a departure from the tables only for persons of "exceptional" condition. McLendon had a 10 percent chance of surviving for more than a year as of March 5, 1985, and the appeals court was not convinced that 10 percent was negligible.
The appeals court also noted that "the Tax Court has long been fighting a losing battle with the various courts of appeals over the proper deference to which revenue rulings are due. Whereas virtually every circuit recognizes some form of deference, the Tax Court stands firm in its own position that revenue rulings are nothing more than the legal contentions of a frequent litigant."
Citing Silco Inc. v. United States, 779 F.2d 282 (5th Cir. 1986) (86 TNT
4-35), Judge Jolly concluded that the IRS was bound by its own revenue ruling
in this case. The court remarked that most cases raising the issue of deference
involve arguments by a taxpayer arguing that a revenue ruling is contrary to
the law. The IRS "ignored the clear language of his own ruling in
declaring deficiencies, and it is precisely this kind of tactic that Silco
declares to be intolerable." Estate of Gordon B. Mclendon, Deceased;
Gordon B. Mclendon, Jr., Independent Executor, V. Commissioner of Internal
Revenue, 81 AFTR2d Par. 98-476 (CA5 1998).
Value of Closely Held Corporations' Stock.
Tax Court Judge John O. Colvin has redetermined the fair market value of stock of two closely held corporations for gift tax purposes, concluding that the taxpayers' estimates were closer to actual fair market value than the Service's estimates.
The court approved of the two methods used by the taxpayers' expert: the income capitalization method and the market or public guideline company method. The Service argued that the plaintiffs'
expert placed too much significance on the low dividend yield, but Judge Colvin agreed with the taxpayers that a prospective minority shareholder "would almost exclusively consider dividend yield rather than discounted cash-flow or income capitalization to estimate the value of stock in either of these companies."
Judge Colvin did agree with the IRS, however, that the plaintiffs' expert improperly included a small stock premium, reasoning that the expert didn't show that these two companies were "riskier merely because they are small." In fact, the expert concluded that the companies were less risky than other comparably sized companies because their business (telephone service) is regulated.
The court found that the IRS's expert failed to adequately consider several facts: (1) the two families involved here intend to retain control over the companies; (2) both companies paid low dividends; and (3) the nonvoting stock of one company had no right to participate in any business decision and the voting stock of the other company had ineffectual voting rights.
Finally, the court applied marketability discounts of 40 and 45 percent and
a discount of 3.66 percent for nonvoting stock, as did the taxpayers' expert. Louise
B. Barnes, Donor, et Al.,V. Commissioner of Internal Revenue, T.C. Memo.
1998-413.
Value of Closely Held Corporation's Stock.
Tax Court Judge Joseph H. Gale has redetermined the fair market value of a closely held corporation for gift tax purposes, concluding that the Service's estimates were closer to the actual fair market value than the taxpayer's estimates. The court found that the discounted cash-flow analysis used by the Service's expert was the most reliable indicator of the construction corporation's value at the time May Rakow transferred the stock to her children and grandchildren. In addition, Judge Gale agreed with the Service's expert that the 45 percent control premium used for construction companies was appropriate and that a 31 percent minority discount rate should be applied to determine the stock's FMV.
Judge Gale rejected Rakow's contention that using the discounted cash-flow approach was not feasible in the construction industry, finding that she failed to show that the company suffered from
inherent business risks, such as poor estimates, delays, and cyclical
demand. May T. Rakow, V. Commissioner of Internal Revenue, T.C. Memo.
1999-177
Gift Taxes -- Valuation of Closely-held Corp. Stock -- Built-in Gains Tax Discount.
Tax Court improperly held that taxpayer-donor couldn't discount FMV of her
closely-held corp. stock gift to account for stocks' potential built-in gains
tax liability: although no liquidation or sale of corp. or its assets was
planned at time of gift, hypothetical willing seller and buyer wouldn't have
agreed on valuation date to price for stock that didn't account for corp.'s
built-in capital gains tax; and tax liability upon liquidation or sale for such
gains wasn't too speculative where General Utilities doctrine was revoked by
'86 TRA. (Eisenberg v. Comm., CA 2, 82 AFTR 2d 98-5757 )
IRS acquiesces in case allowing reduction in gifted stock's value for potential capital gain tax
Last year the Second Circuit held that the value of a gift of closely held
stock could be reduced to reflect built-in capital gains tax on the
corporation's sole asset, improved realty, even though no liquidation or sale
was imminent. IRS has just announced its acquiescence in this holding that a
discount for potential capital gains tax liabilities may be applied in valuing
closely held stock.
Termination of Qtip Trust Will Trigger Gift from Children to Their Mother
A testator used a qualified terminable interest property (QTIP) trust to give his surviving spouse an income stream for life, preserve assets for the children, and save estate tax at the same time. Several years later, the children agreed to terminate the QTIP. They had hoped that no gift tax would be triggered by the termination but IRS privately ruled that they would be charged with making a gift of their remainder interests to their mother.
Facts of ruling. An individual whom we'll call Tom, died on July 30, '85 possessing a revocable trust, a portion of which passed to a QTIP marital deduction trust for his wife, Mary. She was entitled to receive all the income from the QTIP during her lifetime. On her death, the remaining principal was to pass to a trust for the children of Tom and Mary (Children's Trust).
Mary, the trustee of the QTIP, the trustee of the Children's Trust, and the children intend to petition the local probate court for termination of the QTIP and distribution of its entire corpus to Mary, free of trust. The petition will be filed under a state statute that permits the termination of a trust when, owing to circumstances unforeseen by the creator of the trust, the continuation of the trust would impair or defeat his intentions in establishing the trust. The children sought a ruling that their consent to termination of the QTIP would not be a gift by them to their mother.
Children's argument. The children argued that under Rev Rul 98-8, 1998-7 IRB 24, a remainder interest in a QTIP trust is accorded a value of zero when received by the spouse (or is already treated as owned by the spouse for transfer tax purposes) so that the transfer of the remainder to their mother would not be subject to gift tax. In that ruling, a surviving spouse purchased the remainder interest in a QTIP from the remainderpersons for an amount equal to the actuarial value of the remainder interest. The trust then terminated and the entire trust corpus was paid to the spouse, who then paid the purchase price to the remainderman from the proceeds of the trust corpus. The ruling concluded that the surviving spouse made a gift of property equal to the value of the remainder interest in the QTIP trust. One basis for this conclusion was that the spouse acquired an asset (the remainder interest in the QTIP trust) that was already subject to inclusion in her transfer tax base under Code Sec. 2044. Rev Rul 98-8 said that the receipt of an asset that does not effectively increase the value of the recipient's potential gross estate does not constitute adequate consideration for purposes of the gift and estate tax. Thus, the spouse did not receive adequate consideration for the transfer of the purchase price.
IRS rejects children's argument. IRS disagreed that the termination of the QTIP would be gift tax-free. IRS said that the children propose to transfer a valuable property interest to their mother and receive nothing in exchange. Under Code Sec. 2512(b), this transfer for less than adequate consideration would constitute a gift. Further, IRS said that while Rev Rul 98-8 concludes that the receipt of the remainder interest by the spouse didn't constitute adequate consideration for her transfer to the remainderpersons, it doesn't follow that the remainder interest in the letter ruling should be valued at zero (or the transfer of the interest should not constitute a gift). The transfer will deplete the children's potential taxable estate. Also, if they were to transfer the remainder interest to a third party, the transfer clearly would be a gift. The result is the same if the donee is their mother. The fact that the receipt of the remainder interest by their Mother will not increase the value of her potential taxable estate is not pertinent to the determination of the gift tax consequences to the children.
Observation: To put the matter in perspective, assume the QTIP had
assets of $400,000 when Tom died and that the value of the remainder was
$100,000 when the children agreed to terminate the trust. They would be charged
with making a gift of $100,000 to their mother and the assets would be included
in her estate if they remained intact. Similarly, the QTIP trust assets would
have been included in the mother's estate if the gift had not been made.
Assuming the assets (whether owned outright following the gift or held in the
QTIP in the absence of a gift) remained intact until death, mother's estate
would include $400,000. If mother leaves the assets to the children, they would
be in the same position that they would have been in without the gift except
that they had to pay gift tax on $100,000 (or use up part of their unified
credit to avoid tax). The result reached in IRS Letter Ruling 199908033
suggests that terminating the trust would not make sense absent some non-tax
reason for doing so. However, the result could make tax-sense if mother is able
to use the funds that had been in the trust and that she now owns outright to
make gift-tax free annual exclusion gifts to the children over a span of years.
By doing this, she may be able to remove all or a substantial part of the
$400,000 from her estate, a result that wouldn't have been possible had the
QTIP remained intact, unless the trustee had power to appoint QTIP principal to
her, he did so and she used the appointed property to make gifts. IRS Letter
Ruling 199908033
Code Sec. 2702
Vacation Home with Rental Property Qualified as Personal Residence Grit
A grantor retained income trust (GRIT) is a trust to which an individual transfers property and retains an income interest. Code Sec. 2702 generally treats the grantor as making a gift of the full value of the property even though a child or other person will get the remainder only after a set number of years. However, the value of the gift of the remainder is determined under the Code Sec. 7520 valuation tables (resulting in a lower gift tax value) where the trust is funded with a personal residence of the grantor and other requirements are met. ( Code Sec. 2702(a)(3)(A)(ii)) In a recent private letter ruling, IRS concluded that property consisting of a vacation home with a separate rental unit was a personal residence and that a trust holding it was a qualified personal residence trust under Reg § 25.2702-5(c)(2)(C)(ii) qualifying for the favorable personal residence GRIT treatment outlined above.
Facts of ruling. A taxpayer, whom we'll call Jeff Downs, owns property consisting of a residence situated on several acres. The residence includes a separate apartment that's rented to unrelated individuals. Jeff uses the house as his vacation residence for a part of the year. For certain periods, he permits family members and friends to stay in the house rent-free.
Jeff proposes to transfer the parcel of real property containing the home to a trust, the terms of which are intended to satisfy the requirements for a qualified personal residence trust (QPRT) under Reg § 25.2702-5(c). A QPRT is considered to satisfy the statutory requirements for the exception to the 100% gift rule for personal residence trusts. (Reg § 25.2702-5(a)(1))
The proposed trust provides that the income term of the trust is the period that will begin on the date of the trust instrument and end on (i) the date that is a specified (but undisclosed) number of years after the date of the trust instrument, or (ii) the date of Jeff's death, if sooner. At the end of the income term, the property in the trust will pass to a family trust for the lifetime benefit of Jeff's wife, Cathy. Under the terms of the family trust, Cathy will be entitled to the use and occupancy of the residence for her remaining lifetime. On her death, the remaining trust property will pass in trust for the benefit of Jeff's descendants.
The ruling included a number of other facts about the trust's terms and the powers of the trustee that were designed to show that the trust satisfied the requirements for a QPRT.
Relevant reg rules. Reg § 25.2702-5(c)(2)(i) provides that a personal residence of a term holder is either the personal residence of the term holder (within the meaning of the Code Sec. 1034 rules on rollover of gain on the sale of a principal residence that generally were repealed for sales or exchanges after May 6, '97), one other residence of the term holder (within the meaning of the vacation home rental rules of Code Sec. 280A(d)(1) but without regard to the Code Sec. 280A(d)(2) rules on when a taxpayer is considered to have used a dwelling unit for personal purposes), or an undivided fractional interest in either. Reg § 25.2702-5(c)(2)(ii) provides that a personal residence may include appurtenant structures used by the term holder for residential purposes and adjacent land not in excess of that which is reasonably appropriate for residential purposes (taking into account the residence's size and location).
Favorable rulings. IRS issued the following rulings:
(1) The property qualifies as Jeff's personal residence and the rental of the apartment is incidental to the use of the property as a residence.
(2) The trust meets the requirements of a QPRT under Reg § 25.2702-(5)(c).
(3) At the end of the income term of the trust, if Jeff's wife, Cathy, is
living and still married to Jeff, the trust property will pass to the family
trust for Cathy's lifetime benefit. Upon her death, the property will continue
to be held in trust for the benefit of Jeff's descendants. If Jeff survives the
income term, he won't be considered to have retained any interest in the
transferred property that would bring it back into his gross estate under Code
Sec. 2035 through Code Sec. 2038, assuming there is no express or implied
agreement, regarding his continued use of the property after the expiration of
the income term. (Under Rev Rul 70-155, 1970-1 CB 189, co-occupancy by the
donor with the donee, where the donor and donee are husband and wife, does not
of itself support an inference of an agreement or understanding as to retained
possession or enjoyment by the donor.) Therefore, in the absence of an
agreement, the property placed in trust by Jeff won't be includible in his
gross estate if he survives the income term of the trust. IRS Letter Ruling
199906014
Final Regs Allow Flip Unitrusts and Clamp Down On Abuses
Td 8791; Reg § 1.664-1, Reg § 1.664-2, Reg § 1.664-3, Reg § 25.2702-1
In the spring of '97, IRS issued proposed regs relating to charitable remainder trusts and trusts subject to the special valuation rules of Code Sec. 2702. IRS has now finalized these regs with a number of revisions.
Charitable remainder trust background. In general, a charitable remainder trust (CRT) provides for a specified periodic distribution to one or more noncharitable beneficiaries for life or for a term of years with an irrevocable remainder interest held for the benefit of charity. ( Code Sec. 664(d)) There are two types of CRTs:
(1) A charitable remainder annuity trust (CRAT) pays a sum certain at least annually to the beneficiaries.
(2) A charitable remainder unitrust (CRUT) pays a unitrust amount at least annually to the beneficiaries. In general, the unitrust amount is a fixed percentage of the net fair market value of the CRUT's assets valued annually (fixed percentage CRUT). The unitrust amount can instead be calculated under one of two income exception methods (income exception CRUT). Under the first, the unitrust amount is the lesser of the fixed percentage amount or the trust's annual net income (net income method). Under the second, the unitrust amount is determined under the net income method plus any amount of income that exceeds the current year's fixed percentage amount to make up for any shortfall in payments from prior years when the trust income was less than the fixed percentage amount (NIMCRUT method). The shortfall in payments from prior years is commonly referred to as the "make-up amount."
Flip unitrusts. The proposed regs provide specific rules for when a trust may convert from one of the income exception methods of computing the unitrust amount to the fixed percentage method (flip unitrust). The rule was designed for taxpayers who ultimately wanted the unitrust amount to be computed on the fixed percentage method but funded the trust with unmarketable assets that generate little annual income. The final regs expand the availability of the flip unitrust. Specifically, they allow the governing instrument of a CRUT to provide that the CRUT will convert once from one of the income exception methods to the fixed percentage method for calculating the unitrust amount if the date or event triggering the conversion is outside the control of the trustees or any other persons. (Reg § 1.664-3(a)(1)(i)(c)) Permissible triggering events include, for example, marriage, divorce, death, birth of a child, and the sale of an unmarketable asset such as real estate. (Reg § 1.664-3(a)(1)(i)(d)) Impermissible triggering events include the sale of marketable assets and a request from the unitrust recipient or the unitrust recipient's financial advisor that the trust convert to the fixed percentage method. (Reg § 1.664-3(a)(1)(i)(e))
The final regs also provide that the conversion to the fixed percentage method occurs at the beginning of the tax year that immediately follows the tax year in which the triggering date or event occurs. Any make-up amount is forfeited when the trust converts to the fixed percentage method. (Reg § 1.664-3(a)(1)(i)(c))
The flip unitrust allowed by the final regs is the only type of permissible conversion. A CRAT cannot convert to a CRUT, and a CRUT using the fixed percentage method cannot convert to an income exception method, without losing CRT status.
The final regs for flip unitrusts are effective for CRUTs created after Dec. 9, '98 and allow reformations of CRTs to add provisions allowing conversions in more circumstances than would have applied under the proposed regs. (Reg § 1.664-3(a)(1)(i)(f))
Time for paying annuity or unitrust amount. Because IRS believed that certain trustees attempted to abuse the regulatory provisions permitting a trustee to pay the annuity or unitrust amount within a reasonable time after the close of the tax year for which the payment is due, it proposed amending the regs to provide that the payment of the annuity amount or the unitrust amount determined under the fixed percentage method would have to be made by the close of the tax year in which it is due, effective for tax years ending after April 18, '97. IRS subsequently issued Notice 97-68, 1997-48 IRB 11, which provided guidance on complying with the proposed rules for the '97 tax year. The final regs adopt rules that are similar to those in Notice 97-68 but with modifications.
Under the final regs, which apply for tax years ending after April 18, '97, for CRATs and fixed percentage CRUTs, the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which it is due if (a) the character of the annuity or unitrust amount in the recipient's hands is income under Code Sec. 664(b)(1), Code Sec. 664(b)(2), or Code Sec. 664(b)(3); and/or (b) the trust distributes property (other than cash) that it owned as of the close of the tax year to pay the annuity or unitrust amount and the trustee elects on Form 5227, "Split-Interest Trust Information Return," to treat any income generated by the distribution as occurring on the last day of the tax year for which the amount is due. (Reg § 1.664-2(a)(1)(i) and Reg § 1.664-3(g)) In addition, for CRATs and fixed percentage CRUTs that were created before Dec. 10, '98, the annuity or unitrust amount may be paid within a reasonable time after the close of the tax year for which it is due if the percentage used to calculate the annuity or unitrust amount is 15% or less. (Reg § 1.664-2(a)(1)(i)(b) and Reg § 1.664-3(a)(1)(i)(h))
Appraising unmarketable assets. The final regs provide that the value of unmarketable assets held by a CRT must be determined by an independent trustee or by a current qualified appraisal, as defined in Reg § 1.170A-13(c)(3), from a qualified appraiser, as defined in . (Reg § 1.664-1(a)(7)) This change applies for trusts created after Dec. 9, '98. (Reg § 1.664-1(f)(4))
Changes tied to special valuation rules. Code Sec. 2702 provides special rules to determine the amount of the gift when an individual makes a transfer in trust to or for the benefit of a family member and the individual or an applicable family member retains an interest in the trust. The retained interest generally is valued at zero but not where the retained interest is the right to receive fixed payments at least annually or to receive amounts at least annually that are a fixed percentage of the annual fair market value of the property in the trust. Under prior regs, Code Sec. 2702 didn't apply to CRUTs or CRATs and some taxpayers created CRUTs using an income exception method to attempt to pass substantial assets to family members with minimal transfer tax consequences. To prevent this, the final regs provide that unitrust interests in an income exception CRUT that are retained by the donor or any applicable family member will be valued at zero when a noncharitable beneficiary of the trust is someone other than (1) the donor, (2) the donor's U.S. citizen spouse, or (3) both the donor and the donor's U.S. citizen spouse. In these situations, the amount used to calculate the donor's gift tax liability is the value of the property transferred to the trust less the value of the interest passing to charity. The final regs make it clear that Code Sec. 2702 won't apply when there are only two consecutive noncharitable beneficial interests and the transferor holds the second of the two interests. Also, under the final regs, Code Sec. 2702 applies to a flip unitrust if the CRUT doesn't meet one of the exceptions. This change applies for transfers in trust made after May 18, '97. (Reg § 25.2702-1(c)(3))
Prohibition on allocating precontribution gain to trust income. The final regs, like the proposed regs, make it clear that the proceeds from the sale of an income exception CRUT's assets, at least to the extent of the fair market value of the assets when contributed to the trust, must be allocated to principal. (Reg § 1.664-3(b)(4)) However, under the final regs, the governing instrument, if permitted under applicable local law, may allow the allocation of post-contribution capital gains to trust income. Taxpayers do not have to treat the make-up amount as a liability when valuing the assets of a NIMCRUT. These changes apply for sales or exchanges after April 18, '97. (Reg § 1.664-3(a)(1)(i)(b)(5))
Characterizing distributions from CRUTs. Code Sec. 664(b) contains the
ordering rule used to determine the character of the annuity or unitrust amount
in the hands of the recipient. To provide taxpayers with additional guidance,
the final regs add an example of how the ordering rule operates when the
unitrust amount is computed under an income exception method. (Reg §
1.664-3(a)(1)(i)(i))
Code Sec. 2703
Gross Estate -- Family Partnership Interests -- Restrictions on
Liquidation -- Gift Taxes. Transfers to family partnership shortly before decedent's
demise, along with apparent restrictions or reductions in assets' value due to
transfer, were disregarded for valuation purposes. In 6 weeks before her death,
in exchange for ltd. partnership interest worth 40% less than assets
transferred, decedent transferred into partnership assets which represented
over 98% of partnership's value at time of her death. Only discernible purpose
for transaction was to depress value of assets, without any resulting change of
substance, and transfer is properly viewed as testamentary transaction
occurring at decedent's death. Alternatively, Code Sec. 2703, which provides
that property value shall be determined without regard to restrictive
agreements, applies: actions of decedent, without bona fide business purpose,
having sole purpose of depressing value of assets as they passed through estate
is "device" within meaning of Code Sec. 2703(b)(2), and is
disregarded. And, restrictions on decedent's ability to liquidate interest are
disregarded under Code Sec. 2704(b)(2): regs don't support estate's argument
that restrictions must apply to partnership as a whole, not to ltd. partner's
ability to liquidate partner's interest. Alternatively, decedent's transfer is
gift to other partners. Estate's argument that partnership interests held by
decedent and children were in proportion to amounts contributed to partnership,
with any decrease in value attributable to partnership form, was rejected:
decedent held 99% ltd. partner interest, while losing control element, and
children held 1% general partner interest, so interests received weren't
proportionate to contributions. (IRS Letter Ruling 9842003 , United States Tax
Reporter ¶ 144,317 )
Gross Estate -- Family Partnership Interests -- Restrictions on
Liquidation -- Gift Taxes. Transfers to family partnership shortly before
decedent's demise, along with apparent restrictions or reductions in assets'
value due to transfer, were disregarded for valuation purposes. In 6 weeks
before her death, in exchange for ltd. partnership interest worth 40% less than
assets transferred, decedent transferred into partnership assets which
represented over 98% of partnership's value at time of her death. Only
discernible purpose for transaction was to depress value of assets, without any
resulting change of substance, and transfer is properly viewed as testamentary
transaction occurring at decedent's death. Alternatively, Code Sec. 2703, which
provides that property value shall be determined without regard to restrictive
agreements, applies: actions of decedent, without bona fide business purpose,
having sole purpose of depressing value of assets as they passed through estate
is "device" within meaning of Code Sec. 2703(b)(2), and is
disregarded. And, restrictions on decedent's ability to liquidate interest are
disregarded under Code Sec. 2704(b)(2): regs don't support estate's argument
that restrictions must apply to partnership as a whole, not to ltd. partner's
ability to liquidate partner's interest. Alternatively, decedent's transfer is
gift to other partners. Estate's argument that partnership interests held by
decedent and children were in proportion to amounts contributed to partnership,
with any decrease in value attributable to partnership form, was rejected:
decedent held 99% ltd. partner interest, while losing control element, and
children held 1% general partner interest, so interests received weren't
proportionate to contributions. (IRS Letter Ruling 9842003 , United States Tax
Reporter ¶ 144,317 )
TAM Shoots Down Family Limited Partnership Funded Shortly Before Death
Irs Letter Ruling 9842003
Family limited partnerships offer a number of income and transfer tax advantages. However, as illustrated in a recent Technical Advice Memorandum, IRS will deny transfer tax breaks where family limited partnerships are formed or funded soon before death in an effort to reduce transfer taxes.
Facts. An individual, whom we'll call Jane Blair, died with a will in Oct. '95 survived by three adult children, Andrea, Bennett, and Caroline. Jane had executed both a will and a revocable trust (Trust) on Dec. 14, '93. Under the terms of the will, the estate residue passes to the Trust. The trustees of the Trust were Jane and Bennett. Jane retained the right to withdraw part or all of the principal of the Trust at any time. Upon Jane's death, the Trust provided for pecuniary bequests to four charitable organizations; specific bequests of real property to Bennett and Caroline; the establishment of trusts (aggregating $1,000,000 in value) exempt from the generation-skipping transfer tax for the benefit of Jane's grandchildren; and the trust residue passing equally to Jane's three children. During the term of the Trust, the trustees had complete authority to manage and invest all trust property and they could appoint co-trustees and successor trustees, including anyone with a beneficial interest in the trust.
Family partnership. In June '95, Jane, Andrea and Bennett formed a family partnership under the laws of the State of New York. Its stated purpose was generally to purchase, own, maintain, and sell real and personal property; to invest partnership assets; and to carry on enterprises and perform business activity for profit. The general partners have full and exclusive responsibility and control over the management of the business and internal affairs of the partnership and all the rights and powers of general partners as provided by New York State law. No limited partner has the right to participate in the control or management of the partnership or the power to bind the partnership. A limited partner may not withdraw from the partnership unless all of his or her partnership interest is transferred to third parties in accordance with the agreement and the transferees have been admitted as substituted limited partners. No partner may receive any partnership distribution or make a withdrawal from his or her capital account except under partnership agreement provisions dealing with distributions of profits and losses and termination of the partnership.
At the time of formation of the partnership in June '95, Andrea and Bennett each contributed $50 for a ½ % general partnership interest and Jane contributed $9,900 for a 99% limited partnership interest. In Sept. '95, Jane transferred $1.7 million of securities that had been held by Trust to the partnership. Later in September, she transferred a $145,000 money market fund account held by Trust to the partnership. In Oct. '95, just one week before her death, Jane transferred two parcels of real estate, one of which was her personal residence, to the partnership. During the same period, Jane also transferred to the partnership nearly $90,000 in cash and Andrea and Bennett each transferred $10,000 in cash. Thus, over 98% of the value of all partnership assets at Jane's death were transferred by Jane to the partnership during the six week period just before she died.
At the time of Jane's death, the partnership held assets worth over $2.26 million. On her estate tax return, Jane's 99% limited partnership interest was valued at $1,343,400, or 60% of the fair market value of the cash, marketable securities, and real estate that Jane transferred to the partnership within the six week period before her death.
No reduction in value. The TAM applied two alternative theories to value Jane's interest in the partnership. First, the TAM concluded that the entire transaction, including the transfer of assets to the partnership by the Trust, has to be viewed as a singl