Wealth Management Update - 2010 Year-End - Tax Authorities

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FAMILY LIMITED PARTNERSHIPS AND LLCS

Tax Court Finds Transfers of FLP Interests Do Not Qualify for the Gift Tax Annual Exclusion Because Gifts Were Not of Present Interests – Price v. Commissioner, TC Memo 20102

This Tax Court decision provides guidance on the availability of the annual exclusion from gift tax under Section 2503(b) for gifts of interests in family limited partnerships. It is an important case for anyone who plans to engage in this kind of gifting, and it calls for a careful review of the provisions of the partnership or LLC agreement.

In 1976, Walter Price started a company, Diesel Power Equipment Company ("DPEC"), which distributed and serviced heavy equipment. Some time later, Mr. Price made the decision to sell the business. In 1997, he formed Price Investments Limited Partnership as a limited partnership and contributed to it the stock in DPEC and three parcels of commercial real estate. When it was formed, the partnership was owned 1% by its general partner, Price Management Corp., 49.5% by the Walter Price Revocable Trust and 49.5% by Mr. Price's wife's revocable trust. Price Management Corp. was owned by Mr. and Mrs. Price's revocable trusts.

In 1998, the partnership sold the DPEC stock and invested the proceeds in marketable securities. Over the next several years, each of Mr. and Mrs. Price gifted interests in the partnership to their children such that by 2002 the children's cumulative interest in the partnership was 99%. Gift tax returns were filed properly for each year, reporting zero gift tax because of the use of annual exclusion and unified credit amounts. Valuation reports were attached to the gift tax returns indicating substantial discounts for lack of control and marketability (which the IRS stipulated were reported correctly).

The IRS issued the Prices deficiency notices disallowing the use of the gift tax annual exclusion under Section 2503(b) with respect to the transferred partnership interests on the ground that the gifts were of "future interests in property." The Prices argued that their gifts were of present interests because (i) the donees could freely transfer the interests to one another or to the general partner and (ii) each donee had immediate rights to partnership income and could freely assign income rights to third persons. Relying on Hackl, the IRS argued that the transferred partnership interests were future interests because the partnership agreement effectively barred transfers to third parties and did not require income distributions to the limited partners.

The Tax Court agreed with the IRS and applied the methodology of Hackl in concluding that the Prices failed to show that their gifts conferred upon the donees the immediate use, possession or enjoyment of either (i) the transferred property or (ii) the income therefrom.

In its analysis of the "transferred property" prong, the court focused on the terms of the partnership agreement. Specifically, the court notes that the donees have no unilateral right to withdraw their capital accounts; that their rights to transfer and assign partnership interests are restricted; and that a transferee is a mere assignee rather than a substitute limited partner. The Tax Court, citing Hackl, states that transfers subject to the contingency of approval cannot support a present interest characterization.

In its analysis of whether the gifts of the partnership interests afforded the donees the immediate use, possession or enjoyment of "the income therefrom," the court held that (1) the partnership would have needed to generate income at or near the time of the gifts; (2) some portion of that income would have to have flowed steadily to the donees; and (3) the portion of income flowing to the donees had to be readily ascertainable. The Court found that the partnership's income did not flow steadily to the donees since there were no distributions in certain years. Furthermore, the court found problematic the fact that neither the partnership nor the general partner had any obligation to distribute profits, and distributions were secondary to the primary purpose of the partnership in achieving a reasonable, compounded rate of return on a long-term basis.

Tax Court Holds Loan from FLP to Surviving Spouse's Estate Not "Necessarily Incurred" and Interest thereon Not a Deductible Administration Expense; Transfer to FLP Escapes Estate Inclusion under Consideration Exception – Estate of Black v. Commissioner, 113 T.C. 15 (2009)

In this case, the Tax Court objected to a Graegin-type loan arrangement between related entities. It is an important decision to review if you are considering such a loan. This case also considered whether certain transfers of FLP interests are includible in a decedent's estate.

Estate of Black involves the estates of Samuel and Irene Black. Samuel Black owned a large amount of stock in Erie Indemnity Company. In 1993, at the age of 91, Mr. Black, his son and two trusts for Mr. Black's grandchildren contributed their Erie stock to an FLP in exchange for partnership interests proportionate to the fair market value of the Erie stock each contributed. The transaction was initiated to implement Mr. Black's buy-and-hold philosophy with respect to the family's Erie stock, and concerns about his son's marriage and the possibility that his grandsons would sell the stock when their trusts terminated. At the time the FLP was formed, Mr. Black was in good health and retained approximately $4 million in assets outside the FLP.

Mr. and Mrs. Black died within five months of each other, with Mr. Black dying first. There was a liquidity shortfall to pay estate taxes, so the Executor (who was their son) approached several banks about a loan but he did not like the terms, and the banks did not want FLP interests as collateral. The Executor also approached the Erie Company about a loan, but was turned down. Ultimately, the Blacks' son, as general partner of the FLP, undertook a secondary offering of approximately one-third of the FLP's Erie stock. The FLP and Mrs. Black's estate worked out a loan whereby the FLP would lend the estate approximately $71 million to pay, among other things, estate taxes, a charitable legacy and certain expenses in connection with the secondary offering. The interest was payable in a lump sum on a date more than four years from the date of the loan, and the estate had no right to prepay interest or principal, being patterned on the loan approved in the Graegin case.

The Executor computed the interest on the loan to be $20,296,274 and deducted that amount on Mrs. Black's estate tax return, in full, as an administration expense of her estate. The IRS assessed large estate tax deficiencies in both estates, denying the deductibility of the interest paid, and arguing for the inclusion in Mr. Black's estate, under Section 2036, of the Erie stock Mr. Black transferred to the FLP.

The taxpayer won on the 2036 issue, with the Tax Court finding that there was a substantial nontax reason for forming the FLP and that Mr. Black's transfer of the stock to the FLP in exchange for the partnership interest was a bona fide sale for adequate and full consideration in money or money's worth. With respect to the deductibility of the loan interest, the estate argued that the loan was bona fide and similar to the loan blessed by the Tax Court in the Graegin case. The Tax Court ruled for the IRS, holding that the loan was not "necessarily incurred" (and thus not a deductible administration expense) since the FLP could have distributed Erie company stock in redemption of the estate's partnership interest in an amount that could have covered the estate tax, charitable legacy and other expenses. The Tax Court also was troubled by the fact that the Blacks' son effectively stood on both sides of the loan transaction, as general partner of the FLP and as Executor of Mrs. Black's estate.

Tax Court Finds Transfer of an Interest in a Limited Partnership and Timberland to an FLP Was Not Includible in the Decedent's Gross Estate Under Section 2036(a) Because the Transfer Was a Bona Fide Sale For Adequate And Full Consideration – Estate of Shurtz v. Commissioner, TC Memo 201021 (February 3, 2010)

This Tax Court decision provides another Section 2036 victory for the taxpayer by holding that assets transferred to an FLP were not includible in the decedent's gross estate under Section 2036(a) because the transfer was a bona fide sale for adequate and full consideration. This case is particularly taxpayer friendly because the Tax Court focused on the nontax purposes for forming the FLP and was able to overcome several bad facts.

The Decedent, Mrs. Shurtz, died in California in 2002. She was survived by her husband and children. The Decedent and her siblings grew up in Mississippi where their family owned and operated a timberland business.

By 1993, many family members held separate interests in the business. On the advice of counsel, the family formed a limited partnership, Timberlands LP, to manage and operate the business. A corporation was formed which owned a 2% GP interest in Timberlands LP. The Decedent and her two siblings each owned one-third of the stock of the GP and the Decedent owned a 16% LP interest.

After Timberlands LP was formed, the Decedent and her siblings raised concerns about protecting the family business from "Jackpot Justice" in Mississippi. They were concerned that they could be sued and a judgment entered against them and they could lose control of the business. To avoid this problem, their attorney recommended that each family hold its Timberland LP interest in a separate limited partnership. This recommendation was followed so that the active timber business was held in Timberland LP and the equity ownership was held in several new FLPs, one of which the FLP created by the Decedent.

The Decedent also wanted to give her children and grandchildren interests in 750 acres of timberland that she acquired from her parents.

In 1996, The Decedent and her husband formed an FLP. The purposes of the FLP were (1) to reduce the estate (2) provide asset protection and (3) provide for heirs. The Decedent transferred a 6.6% interest in the 750 acres to her husband who in turn received a 1% GP interest in the FLP. The Decedent contributed the balance of her interest in the 750 acres and her 16% LP interest to the FLP for a 1% GP interest and a 98% LP interest in the FLP.

The FLP agreement had substantial restrictions designed to keep persons outside the family from acquiring interests in the FLP.

Between 19962000, the Decedent made 26 gifts of .4% LP interests to her children and grandchildren. When the Decedent died in 2002, she held a 1% GP interest and a 87.6% LP interest in the FLP.

The IRS contended that the value of the assets the Decedent contributed to the FLP were includible in the value of her gross estate under Section 2036.

The "bad facts" in this case included the following: (1) the FLP did not maintain books of account as specifically required in the partnership agreement; (2) the partnership bank account was not set up until almost four months after formation of the FLP, and after two months as a checking account, it was changed into a money market account; (3) the Decedent and her husband paid some of the FLP's expenses from their personal bank accounts, being reimbursed by the FLP for some payments and having others credited to their capital accounts; and (4) there were not always proportional distributions from the FLP to its partners.

The Tax Court reviewed the management style and operations of the LPs and the Judge noted that the entire family was conscientious about managing the family timber business, had a mission statement and held annual meetings in Mississippi.

The Tax Court found that transfer to the FLP was a bona fide sale because protecting the assets from potential litigants and using the FLP to facilitate the active management of the assets were legitimate and significant nontax reasons for its creation. The Court acknowledged that reducing the estate tax was a motivating factor, but went on to say there were valid and significant nontax reasons for establishing the partnership – therefore, the bona fide sale element was satisfied.

The Court found that the Decedent received an interest in the FLP that represented adequate and full consideration because (1) the participants in the FLP received interests proportionate to the value of the property each contributed; (2) the respective contributed assets were properly credited to the transferors' capital accounts; (3) distributions required negative adjustments to distributee capital accounts; and (4) there was a legitimate and nontax reason for forming the FLP. Therefore, the FMV value of the Decedent's interest in the FLP, rather than the FMV of the assets she contributed to the FLP was includible in her estate.

Since the Tax Court found that a bona fide sale for adequate and full consideration occurred, the FMV of the property the Decedent contributed to the FLP was not includible in her gross estate under Section 2036.

Federal District Court Finds Transfer of Interests in LLC to Children Does Not Qualify for the Annual Gift Tax Exclusion – Fisher v. Commissioner, No. 1:08CV00908 (March 11, 2010)

A U.S. District Court in Indiana found the transfer of interests in a LLC to children did not qualify for the annual gift tax exclusion because the interests were considered "future" rather than "present" interests in property due to operating agreement restrictions on the children's rights relating to the property.

The Fisher parents transferred an LLC, in its entirety, to their 7 children over the course of 3 years using annual exclusion gifts. The LLC owned undeveloped land in Michigan. The Fishers presented three arguments in support of their claim that these were present interest gifts, all of which were rejected by the court. First, the children had the unrestricted right to receive distributions from the LLC. The court said since the timing and amount of any distributions were within the exclusive discretion of the Manager of the LLC, the right to such distributions was not a "substantial present economic benefit." Second, the children had the unrestricted right to use the land which was the primary asset of the LLC. The court said there was no indication that the right to use the land was transferred with the LLC interests, and, even if it was, "the right to possess, use, and enjoy property, without more, is not a right to a, "substantial present economic benefit." And third, the children had the unrestricted right to transfer their LLC interests. The court noted that the operating agreement contained a right of first refusal, allowing the LLC to match any offer and to pay with a promissory note of up to 15 years. Consequently, the court concluded that this effectively prevented the children from transferring their interests in exchange for immediate value.

This case sheds light on what sort of "use" constitutes present economic benefit (it appears a right to use the real property held by an entity does not) and how to treat a right of first refusal. A right of first refusal appears to be a sufficient transfer restriction to cause a partnership or LLC interest to fail the property test, but it is unclear what role the payment terms play.

8th Circuit Finds Limited Partnership's Transfer Restrictions Disregarded when Valuing Stock for Gift Tax Purposes – Holman v. Commissioner, 2010 WL 1331270 (April 7, 2010)

The 8th Circuit, in affirming the Tax Court, found that a limited partnership created by a couple to hold Dell stock in trust for their children could not claim that the partnership's transfer restrictions constituted a bona fide business arrangement. Therefore, under §2703, the restrictions could be disregarded when valuing the stock for gift tax purposes and applying smaller lack of marketability and minority interest discounts than claimed by the donors.

The Tax Court had held that the transfer restrictions were designed principally to discourage the children's dissipation of the wealth transferred to them by way of gift, and said restrictions did not constitute a bona fide business arrangement within the meaning of §2703(b)(1).

The Holmans argued that the Tax Court applied an overly restrictive definition of the phrase "business arrangement" and effectively imposed an "operating business nexus." In affirming the Tax Court decision, the 8th Circuit rejected the Holmans' claims and reasoned that "context" matters when analyzing whether a restriction constitutes a bona fide business arrangement; in this case, there was no "business," active or otherwise.

GIFT TAX CASES AND GUIDANCE

Tax Court Holds that Gift Tax Paid with Respect to Decedent's Deemed Gifts of Remainder Interests in QTIP Property Are Includible in her Gross Estate under Section 2035(b) Estate of Morgens v. Commissioner, 133 T.C. 17 (2009)

Anne Morgens and her husband established a revocable inter vivos trust in a community-property state. After Mr. Morgens' death, the portion of the trust representing his one-half of the community property was allocated to a residual trust for Mrs. Morgens, for which a QTIP election was made. During Mrs. Morgens' lifetime, the residual QTIP trust was divided into two trusts, and Mrs. Morgens made gifts of her qualifying income interests to both trusts, which, in turn, triggered deemed transfers of the remainder interests under Section 2519. The Trustees of the QTIP trusts paid the gift taxes on these deemed transfers.

Mrs. Morgens died within three years of the transfers. Her Executor did not include the amounts of gift tax paid by the Trustees of the QTIP trusts on her estate tax return on the theory that those amounts were not gift tax paid by Mrs. Morgens within three years of her death. The IRS audited the return and determined an estate tax deficiency of approximately $4.6 million.

The IRS argued that the gift tax amounts were includible in Mrs. Morgens' gross estate under Section 2035(b) because Mrs. Morgens was personally liable for the gift tax as the deemed donor of the QTIP, even though she would have a right of recovery from the Trustees who paid it under Section 2207A(b). The Estate argued that applying Section 2035(b) to the gift tax paid by the Trustees would result in an increased estate tax burden contrary to the legislative intent of the QTIP regime. More specifically, the Estate contended that because the ultimate responsibility for paying the gift tax on the Section 2519 deemed transfers lies with the Trustees of the QTIP trusts, Section 2035(b) does not apply.

The Tax Court agreed that Congress intended that, as between QTIP recipients and the surviving spouse, it is the QTIP recipient who should bear the ultimate financial burden for the transfer taxes. However, the Court does not believe that, by allocating the financial burden for gift tax to the recipients of the QTIP Congress shifted to them liability for the gift tax. Section 2207A(b) does not provide that the donees of the QTIP are liable for the applicable gift tax – rather, it refers to the surviving spouse's right to recover from the donees the gift tax paid. The gift tax liability remains with the donor, and, because the QTIP regime treats the surviving spouse as the deemed donor of the QTIP, the gift tax liability attributable to a Section 2519 deemed transfer remains with the surviving spouse.

Over the Estate's objections, the court found that for purposes of Section 2035(b) the deemed transfer of the QTIP is in this case similar to a net gift. The Tax Court previously held in Estate of Sachs v. Commissioner that the phrase "gift tax paid by the decedent or his estate" in Section 2035(c) included gift tax attributable to net gifts made by a decedent during the three-year period before his death, even though the donees of the net gift are contractually obligated to pay the gift tax.

The court also noted that if, as a result of a lifetime disposition of the qualifying income interest, the inclusion of the QTIP uses up some or all of the surviving spouse's unified credit, the surviving spouse may not recover the credit amount from the remaindermen. The court states that Congress' refusal to restore the surviving spouse's unified credit undercuts the Estate's argument that Congress intended to hold the donees liable for the gift tax on gifts of QTIP interests under Section 2519.

The court holds that an exception from Section 2035(b) for gift tax paid on QTIP transfers would encourage transfers of QTIP property in contemplation of the surviving spouse's death, which is inconsistent with the goal of Section 2035(b). Without a clear legislative mandate to except gift tax liability of the surviving spouse on Section 2519 transfers from the application of Section 2035(b), the court would not infer such an exception.

IRS Alerts Taxpayers that it Intends to Issue Guidance under Section 2511(c) – IRS Notice 201019 (February 16, 2010)

Section 2511(c) provides that, notwithstanding any other provision of Section 2511 and except as provided in the regulations, a transfer in trust is treated as a transfer of property by gift unless the trust is treated as wholly owned by the donor or the donor's spouse under the grantor trust provisions.

Some advisors interpreted 2511(c) to mean transfers to wholly-owned grantor trusts during 2010 will not be treated as completed gifts for gift tax purposes. IRS Notice 201019 clarifies that such an interpretation is incorrect and that gifts to grantor trusts during 2010 may be completed gifts using the same criteria as was in effect on December 31, 2009.

The Notice clarifies that transfers in trust, which would otherwise be subject to gift tax are not excluded from the tax merely because the transfers would not be taxed under Section 2511(c). Section 2511(c) broadens the types of transfers subject to transfer tax to include certain transfers to trusts that, before 2010, would have been considered incomplete and, thus, not subject to the gift tax.

Therefore, a transfer made in 2010 to a trust that is not treated as wholly owned by the donor or the donor's spouse under the grantor trust rules is considered to be a transfer by gift of the entire interest in the property under Section 2511(c). The gift tax provisions in effect on December 31, 2009 continue to apply during 2010 to all transfers made to any other trust to determine whether the transfer is subject to gift tax.

Ludwick v. Comm'r, T.C. Memo. 2010104 (May 10, 2010)

In this case, the Tax Court held that a contribution of a tenancy-in-common interest in a personal residence to a qualified personal residence trust was entitled to a 17% marketability discount from its full fair market value.

Husband and wife purchased real property in Hawaii as tenants in common. Husband and wife then created separate qualified personal residence trusts and transferred their one-half undivided interests to the trusts. On their gift tax returns, husband and wife valued their separate one-half undivided interests in the property at a 30% discount. The IRS allowed discounts of only 15%.

In its decision, the Tax Court noted its dissatisfaction with the appraisals prepared by both the taxpayers and the IRS. The Tax Court ultimately decided to discount the tenancy in common interest to reflect the cost of partition and the lack of marketability caused by the buyer's inability to sell the property quickly for its full fair market value. Based on its calculations, the Tax Court determined that a discount of approximately 17% should apply.

Step Transaction Doctrine Applies to Aggregate Gifts and Sales to Trusts

In Pierre v. Commissioner, T.C. Memo 2010106 (May 13, 2010), the Tax Court held that the step transaction doctrine applied to collapse the taxpayer's gifts and sales of LLC membership interests to trusts. This case addresses different issues related to the transaction involved in Pierre v. Commissioner, 133 T.C. No. 2 (August 24, 2009), whereby the Tax Court held that gifts and sales of membership interests in a single member LLC did not preclude valuation discounts because, for gift tax purposes, the single member LLC was not a disregarded entity.

Twelve days after funding a single member LLC, the taxpayer – on the same day – transferred her entire interest in the LLC to two trusts. The taxpayer gifted a 9.5% interest to each trust, and sold a 40.5% interest to each trust for a promissory note.

The Tax Court collapsed the gift and sale to each trust for valuation purposes and treated the transfers as an aggregate transfer of a 50% interest to each trust. The lack of control discount was decreased from 10% to 8%. The taxpayer's valuation expert admitted that the control discount would be lower for a 50% interest because, for example, it could block the appointment of a new LLC manager. The IRS did not contest the 30% lack of marketability discount.

The Tax Court stated that the main reasons for collapsing the gifts and sale were:

The gifts and sales occurred on the same day.
No time elapsed between the gifts and sales other than the time it took to sign four documents.
The taxpayer intended to transfer her entire interest in the LLC without paying gift tax. There was no nontax reason for splitting the transfer.

Each trust's capital account in the LLC ledger was labeled "gift transaction."

United States v. MacIntyre, S.D. Tex., No. 102812, (complaint filed 8/6/10) – U.S. government sues estate and donees of J. Howard Marshall II for unpaid gift taxes

The U.S. government is suing the estate and donees of J. Howard Marshall for a combined $85 million of unpaid gift and GST taxes. The Complaint alleges that between 1993 and 1995 Marshall made more than $109 million in gifts to his ex-wife, son, and various other individuals and trusts. The IRS had previously issued deficiency notices to Marshall's estate for gift and GST taxes, then later entered into stipulations about the amounts owed. Marshall's estate failed or refused to fully pay the debts claimed. Since the estate did not pay, the government claims that the donees of the gifts were automatically personally liable.

In addition to seeking personal liability from all donee trusts and individuals, the government is suing the executors of Marshall's estate, his ex-wife's estate and the trustees of Marshall's and his ex-wife's trusts for personal liability. The government argues that under federal law a personal representative that pays a debt of the decedent prior to paying a government claim is personally liable to the government. Moreover, the government avers that under the relevant state law – Texas – a personal representative must preserve sufficient assets to pay tax liabilities of the decedent in accordance with the priorities established under Texas law and if he or she fails to do so, it subjects the representative to personal liability. The government alleges that the executors and trustees distributed the estates and trusts without paying the government and therefore breached their duties to the government and are personally liable.

The government is also seeking a 10% litigation surcharge under the federal Debt Collection Procedures Act.

ESTATE AND GST TAX CASES

Tax Court Holds Deficiency Notice Invalid where IRS Sends Notice to Address on Estate Tax Return, despite Having Notice of Executor's New Address – Estate of Rule v. Commissioner, TC Memo 2009309

This case addresses the issue of whether the IRS mailed an estate tax deficiency notice to the estate's last known address if the IRS mailed the notice to the address shown on the estate tax return, despite having notice that there was a new address for the executor. The deficiency notice was returned by the postal service marked "Attempted Not Known." The IRS did not issue another deficiency notice after the original one was returned because the deadline for issuing a deficiency notice to the estate had passed.

The Tax Court held that the IRS knew at the time the deficiency notice was issued that the estate's address had changed, and that the IRS therefore failed to use reasonable care and diligence in mailing the notice to the estate's last known address. The deficiency notice was held to be invalid, and, accordingly, the estate's motion to dismiss for lack of jurisdiction was granted.

Estate is Not Entitled to an Estate Tax Charitable Deduction for the Amount Received by a Charitable Trust Pursuant to a Settlement Agreement — PLR 201004022 (September 15, 2009)

The IRS held that an estate was not entitled to an estate tax charitable deduction for the amount paid to a charitable trust pursuant to a settlement agreement.

The Decedent's Will made a number of specific bequests and created trusts for his son and other relatives which provide that the remainder interest in the trusts are distributable to a charitable trust which he created. However, the Will contained no residuary estate provision.

The Decedent's sole heir was his son who argued that he was entitled to the Decedent's residuary estate. The charitable trust argued that the omission of the residuary clause from the Will was a scrivener's error and that the Decedent's intent was to leave his residuary estate to the charitable trust. The attorney who drafted the Will confirmed this in an affidavit. After months of negotiations, the son and the charitable trust settled the dispute and executed a settlement agreement.

The issue presented in this ruling was whether the estate could take an estate tax deduction for the amount payable to the charitable trust under the settlement agreement.

The IRS determined that it has been established that the parties to a settlement agreement are only entitled to federal estate tax deductions to the extent that they have an enforceable right under properly applied state law. Therefore, the question was whether the charitable trust had an enforceable right under state law to receive the payment under the settlement agreement.

Although there is a preference under the applicable state law not to allow the passing of an estate through intestacy, when there is a valid Will, there is also a presumption that heirs of an estate are not to be disinherited unless it is through the plain language in the Will. Additionally, although a court is allowed to consider external evidence when interpreting a Will, that evidence is only allowed when the Will is ambiguous.

Since the Decedent's Will did not conflict with the distribution of the residuary clause through intestacy, there was no reason under state law for the court to examine extrinsic evidence such as the attorney's affidavit.

Therefore, the IRS held that the charitable trust was not entitled to the settlement proceeds under applicable state law and the estate was not entitled to the charitable deduction for the settlement amount.

Federal Court of Claims Holds that Primary Executor of Estate Was Not Entitled to Reissuance of $10 Million Refund when Check Was Previously Issued to and Negotiated by an Ancillary Executor – Curtin v. United States, Fed. Cl. No. 09109 T (February 26, 2010)

The Federal Court of Claims recently denied a U.S. executor's claim for a federal tax refund when the IRS had previously issued a refund check to a non-U.S. ancillary executor. At issue was the estate of a deceased U.S. citizen who died domiciled in France. Unrelated individuals, the Plaintiffs, administered her estate in the U.S. The decedent's son served as an ancillary executor in France.

The U.S. executor initially paid from the estate about $17.5 million in federal estate taxes and requested an extension of time to file along with the payment of the tax. Subsequent to this, the son filed an estate tax return claiming a $10 million refund, which the IRS paid to him. The son's agent negotiated the check.

The U.S. executor subsequently filed for a $5 million refund, which was denied on the basis that the refund had already been paid. The U.S. executor filed suit, claiming that the check was forged or fraudulently negotiated and the IRS breached an implied in fact contract between it and the U.S. executor. The Court of Claims disagreed. Because the check was issued to the son and duly negotiated, no forgery or fraud was present. Moreover, the court held that the U.S. executor failed to establish a basis for an implied in fact contract.

IRS Announces Two-Year Renewal of Art Advisory Panel (February 23, 2010)

The IRS recently announced its decision to renew for an additional two years the charter for the Art Advisory Panel. The Art Advisory Panel assists the IRS by reviewing and evaluating the acceptability of appraisals submitted by taxpayers with respect to the fair market value of art. Membership on the Panel is comprised of museum directors, curators, art dealers and auction representatives.

The Art Advisory Panel has played an important role in the eye of many courts deciding issues of art valuation in federal tax cases. For example, in Stone v. United States, 99 AFTR.2d 20072992, aff'd, 103 AFTR.2d 20091379, the court emphasized that the Panel represented a "collection of experts" and found that on account of the fact that the members are not paid and are not told the purpose of the valuation (e.g., income tax valuation versus transfer tax valuation), the Panel is "extremely credible" and "unbiased." Critics point to the close-knit nature of the art community in questioning whether the Panel's evaluations are actually all that unbiased. Nonetheless, the Panel is here to stay, at least for the next two years.

6th Circuit Finds Regulation Reasonable on Generation-Skipping Transfer Tax – Estate of Timken, 2010 WL 1253627 (April 2, 2010)

The 6th Circuit found that Treasury Regulation §26.26011( b)(1)(v)(A), stipulating that the grandfathering exemption to the generation-skipping transfer tax ("GST") does not apply when there is a post-statute exercise of lapse of a general power of appointment, is reasonable.

The Timken estate trust became irrevocable in 1968, before passage of the GST, with the death of the Settlor ("Timken"). The trust granted Timken's widow a general power of appointment over trust assets, and, provided that if the power lapsed, the remaining assets would be divided for Timken's nieces and nephews. The widow died in 1998 without appointing successors and, consequently, her general power lapsed. The trust assets passed to Timken's nieces, nephews, grandnieces and grandnephews.

The court noted that §2601 is ambiguous as to whether the grandfathering exemption applies to an irrevocable trust that does not mandate a generation-skip, but permits a beneficiary to use a discretionary power of appointment to make a generation-skipping transfer. Treasury Regulation §26.26011( b)(1)(v)(A) permits application of the GST to post-statute exercises and lapses of general powers of appointment.

The court found that the regulation resolves the statutory ambiguity in the same way as other regulatory amendments and is therefore reasonable.

No Estate Tax Apportionment against Payable on Death Accounts

In Estate of Sheppard v. Schleis, 2010 WI 32 (Wis. May 4, 2010), the Wisconsin Supreme Court ruled that, in the absence of any tax apportionment directions by the decedent, a beneficiary of a payable-on-death account is not liable for any estate tax imposed on the decedent's estate.

The decedent died without a Will. Other than the payable-on-death accounts which passed directly to the beneficiary, the decedent's estate passed by probate to his heirs at law.

The executors of the decedent's probate estate sought reimbursement from the beneficiary of the payable-on-death accounts for the portion of federal and state estate taxes attributable to those accounts.

The executor first argued that payable-on-death accounts fall under Internal Revenue Code ("IRC") Section 2036 because the decedent had a retained interest in those accounts. If the decedent had a retained interest under IRC § 2036, the executors could exercise their right to recover estate taxes under IRC § 2207B. However, the court rejected this argument, stating that payable-on-death accounts do not fall under IRC § 2036 because the decedent did not relinquish any rights to the accounts during his lifetime and the beneficiary did not possess a remainder interest during the decedent's lifetime.

The executor also argued that, since Wisconsin does not have an estate tax apportionment statute, there is a common-law right to equitable apportionment of estate tax. The court rejected this argument also, stating that in the absence of any tax apportionment directions by the decedent, estate taxes are to be paid from the residuary estate.

New York and Florida Joins Sixteen Other States in Enacting Formula Clause Fixes

State legislatures are catching the ball that the Federal legislature dropped in permitting the Federal estate and generation-skipping transfer ("GST") taxes to lapse in 2010. New York and Florida are now among eighteen states that have enacted legislation that addresses the interpretation of dispositive instruments that include formula clauses. In New York, for decedents who die in 2010, any bequest that is based on the amount that can pass free of Federal estate or GST taxes shall be read as though the Federal law in effect on December 31, 2009 still applied. In Florida, a fiduciary or any beneficiary can bring an action to have a Court construe the document in accordance with the Settlor's intent.

New Jersey Federal District Court Finds that the IRS Abused its Discretion in Disallowing Extension of Time to File Estate Tax Return

In Estate of Proske v. United States, Civil Action No. 09CV670 (DMC) (USDC D.N.J. May 25, 2010), the New Jersey District Court found that the IRS abused its discretion in disallowing the estate an extension of time to file its Federal estate tax return.

The executor of the estate failed to file an estate tax return and a request for an automatic six-month extension of time to file the return within nine months of the decedent's date of death. The extension request was filed approximately one month after the estate tax return due date, together with payment in the amount of $1,800,000 for the estimated tax. The attachments to the Form 4768 extension request explained that the filing delay was due to the (1) the estate's lack of sufficient liquid assets to make payment, (2) a difficulty in calculating the marital deduction and, thus, the taxable estate, and (3) a delay in obtaining appraisals for certain estate assets. During the course of litigation, the executor of the estate further explained that she was concerned that she could not certify, under penalty of perjury, the information required to be reported in Form 4768.

The IRS denied the extension request simply because the "application was filed after the due date for the return." When the estate did file the return, the IRS assessed a $305,130 late filing penalty with interest which the estate paid but then sought to have refunded to it. The case came before the District Court upon cross-motions for summary judgment which the Court ultimately granted to the estate. In so doing, the Court noted that, pursuant to Treasury Regulation Section 20.60911( c), the IRS has the discretion to grant an extension of time to file a return even if an automatic extension request is not timely filed if, inter alia, it was impossible or impracticable to file a reasonably complete return when due.

The Executor argued that the estate had shown good cause for the delay which the IRS, in an abuse of its discretion, failed to consider. The Court agreed, noting that there was no record of whether or how the IRS had considered the estate's explanation for the filing delay. As a result, the Court stated that the estate tax return is to be treated as having been timely filed and the refund request is to be granted.

Estate of Stewart v. Commissioner, 2d Cir., No. 075370ag (8/9/10) – Court finds Tax Court erred when it apportioned entire value of a Manhattan brownstone to a Decedent's estate when Decedent transferred 49% of the property to her son a few years before her death

In this case the higher court reversed a lower court's inclusion of the entire value of a real property in the Decedent's estate when the decedent had transferred a portion of the property to her son during her life.

Specifically, prior to her death the Decedent transferred a 49% interest in a Manhattan brownstone to her son who lived with her on 2 of the floors. The Decedent and her son continued living on 2 of the floors until the Decedent's death and leased the other 3 floors to a tenant. All income and most expenses on the rental portion were paid to and borne by the Decedent for the rest of her life.

The son argued there was an agreement to reconcile the income and expenses of the brownstone to a property in East Hampton that was also co-owned by them. In prior years tenants in the East Hampton property would pay either the Decedent or her son, then they would split the money every few months. After the transfer of the 49% in the brownstone, the Decedent received all income from the tenant in the brownstone and paid most of the expenses, but the son received all rent from the East Hampton property and did not split the proceeds with the Decedent.

The tax court found there was an implied agreement of retained enjoyment and included the entire property in the Decedent's estate under §2036.

The higher court vacated the lower court's ruling. This court stated that "co-occupancy of residential premises by the donor and donee is highly probative of the absence of an implied agreement." The Court also explained that two factors are particularly significant in determining whether there is an implied agreement for retained possession or enjoyment of a residential property: (i) continued exclusive possession by the donor and (ii) withholding possession from the donee.

The higher court found that the son enjoyed the benefits of the residential portion of the 49% and at least some of the benefits of the rental portion and remanded for a determination of how much of the rental portion the decedent retained. The benefits to the Decedent's estate is a potential 42.5% discount for lack of control and marketability and the exclusion of $125,000 of appreciation from the estate.

Estate of Stick v. Commissioner, T.C., No. 1638308, T.C. Memo. 2010192 (9/1/10) – Loan interest paid by Trust held nondeductible in decedent's estate because it was unnecessary

After Decedent's death, his trust borrowed $1.5 million from Decedent's Foundation to pay his estate tax liabilities (aka a "Graegin" loan). The trust claimed deductions for the interest on the loan under IRC §2053.

The IRS would not allow the deductions because the estate had sufficient liquid assets to pay its estate tax liabilities and the Regulations only allow deductions of administrative expenses that are actually and necessarily incurred in the administration. The Court agreed that since there were sufficient liquid assets, it was not necessary to take out the loan and the interest was therefore nondeductible.

Estate of La Caer v. Commissioner, 135 T.C. No. 14 (9/7/2010) – Court limits amount that surviving spouse was entitled to claim for tax on prior transfers under §2013

This case involves credits for tax on prior transfers under IRC §2013. The credit amount varies based on the number of years between the two taxpayers' deaths. In this case husband died first and his wife died three months later. Under §2013, if the taxpayers died within 2 years of each other, the credit amount is the lesser of two limits. The first limit is the amount of the federal estate tax attributable to the transferred property in the estate that has already been taxed. The second limit is the amount of the federal estate tax attributable to the transferred property in the estate that has not yet been taxed.

The husband's personal representatives purposely caused certain of the husband's assets to not qualify for the marital deduction and therefore be taxed in the husband's estate. The husband's estate paid approximately $200k federal estate tax and $25,000 in Nevada estate tax. The Nevada estate tax is a "pickup" or "sponge" tax in that Nevada imposes a tax in the amount of the maximum credit allowable against the federal estate tax for payment of state death taxes.

The wife's estate claimed a credit in the full amount of all death taxes paid by the husband's estate, without taking into account any limits under §2013. The estate argued that the only portion of the husband's estate that was subject to estate tax was the nonmarital portion and, therefore, the limitations on the tax credit were not triggered when the husband passed no other property subject to the estate tax. The estate argued further that since the Nevada tax was essentially a portion of the federal tax paid to the state, it should also be given a credit. The tax court rejected both arguments, stating that the limitations apply and the state tax was not entitled to a credit.

The wife's estate also filed an amended return in which it deducted the husband's estate tax payment as a debt of the wife. The tax court also denied this deduction because the wife's estate did not introduce any evidence showing that the taxes were actually paid with assets in the wife's estate.

CASES INVOLVING FORMULA AND DEFINED VALUE CLAUSES

Eighth Circuit Upholds Formula Disclaimer Over Public Policy Objections Estate of Christiansen v. Commissioner, 104 AFTR 2d 20097352 (8th Cir. 2009)

In a unanimous decision, the Eighth Circuit upheld over the IRS' public policy objections a formula disclaimer which passed property to charity. This is an important case, as its holding might be broadly applied not just to formula disclaimers passing property to charity, but to defined value clauses in general, including those used in conjunction with gifts or sales of business interests to intentionally defective grantor trusts.

In her will, a decedent left her entire estate to her daughter. The will provided that any disclaimed assets were to pass 75% to a CLAT and 25% to a private foundation. The daughter made a formula disclaimer, in effect disclaiming a fractional share of the decedent's estate exceeding $6.35 million. The decedent's estate tax return reported the estate's value at just over $6.5 million. Based on that value, about $120,000 was to pass to the CLAT and about $40,000 was to pass to the foundation. On audit, the IRS and the estate agreed to increase the gross estate from $6.5 million to $9.6 million (based largely on adjustments to discounts that the estate took on limited partnership interests). Pursuant to the disclaimer, the additional $3.1 million of estate tax was to pass to the CLAT and foundation as if there were no additional tax.

The Tax Court held that the 75% disclaimer to the CLAT was not a qualified disclaimer due to technical violations of the Disclaimer Regulations. That finding was not at issue in the appeal.

With respect to the 25% passing to the foundation, the IRS allowed the $40,000 charitable deduction for the pre-adjustment disclaimer amount, but not for the additional amount passing to the foundation as a result of the adjustment. The IRS made two arguments against the increased deduction. First, it argued that any increased amount passing to the foundation was not deductible because it was contingent on the determination of the final estate tax value, and the Regulations provide that a charitable deduction is not available where it is "dependent upon the performance of some act or happening." The court rejected that argument, finding that while the transfer must be complete at the date of the decedent's death, there does not necessarily need to be an agreement on the value of the transfer at that time. In this case, the foundation's right to receive 25% of the disclaimed amount was certain; the only thing that was uncertain was the value of that 25%.

The IRS's second argument was the same argument that the IRS made successfully in Proctor v. Commissioner, 142 F.2d 824 (4th Cir. 1944)—that is, that the transfer violated public policy because it reduced the IRS' incentive to audit the return. The court rejected this argument as well, even though the formula disclaimer "may marginally detract from the incentive to audit" and, in some situations, would permit a charitable deduction equal to the entire increase in the value of the estate. The court gave three reasons for its holding. First, it noted that the IRS' role is not merely to maximize tax receipts, but to enforce the tax laws. Second, there is no evidence of a clear Congressional intent suggesting a policy to maximize incentives for the IRS to audit returns; on the other hand, there is a clear policy of encouraging charitable donations by allowing charitable deductions. Third, there are other mechanisms that offset the decreased incentive to audit, including (a) the executor's fiduciary duty to accurately report estate values and (b) the contingent beneficiary (in this case the foundation) having an interest in ensuring that the executor does not underreport the value of the estate. Accordingly, the Eight Circuit affirmed the Tax Court's holding that the formula disclaimer clause was not against public policy, and that the estate was entitled to a deduction for the full amount passing to the foundation.

Tax Court Upholds Defined Value Gift in which LLC Interests Given to the Donor's Children and Charities. Estate of Petter v. Commissioner, TC Memo 2009280

On the heals of Christiansen, the Tax Court upheld a defined value clause over the IRS' public policy objections, this time in the context of a part-gift, part-sale of LLC interests. As with Christiansen, this is an important taxpayer victory in the defined value clause arena.

Anne Petter inherited a large amount of UPS stock from her uncle. She consulted an estate planner who recommended a number of techniques to meet her goals, including (a) involving her children in the management of her newly acquired wealth and (b) providing for local charities. One of those techniques involved having Anne contribute all of her UPS stock to an LLC. Anne also created two defective grantor trusts, one for each of her children. She transferred LLC units to each child's trust, partly as a gift and part as a sale. The gift portion was stated as amount equal to 10% of the trust's assets, and the sale portion was stated as 90% of the trust's assets. In addition, Anne donated LLC interests to two local charities.

A formula clause was used to divide the LLC interests between the trusts and charities. The transfer to each trust was stated as "the number of units that equals one-half of the maximum dollar amount that can pass free of federal gift tax." As part of the transfer documents, the trustees of the trusts agreed, as a condition of the gift, that if the value of the units it received was finally determined for gift tax purposes to exceed the originally determined amount, then it would transfer the excess to the charities. The sale to each trust was stated as "the number of units that equals a value of $4,085,190 as finally determined for Federal estate tax purposes," with any excess passing to the charities. Again, the trustees of the trusts agreed, as a condition of the sales, that if the value of the interests were adjusted upward, they would transfer additional LLC interests to the charities. Similarly, the charities agreed that, in the event of any downward adjustment, the charities would transfer a portion of the LLC interests to the trusts.

The LLC units were valued by a qualified appraiser who determined that a discount of over 50% was appropriate, and the LLC units were allocated among the trusts and charities accordingly. On audit, the IRS disallowed a significant portion of the discount, which had the result of increasing the amount passing to the charities based on the formula clauses. The IRS also disallowed any increase in the charitable deduction and asserted that the sales were for less than adequate and full consideration, resulting in gift tax.

Again, the IRS argued that the formula clause was void against public policy based on Proctor. The Tax Court did not agree, finding that this case was closer to Christiansen (in which a donor gave away a fixed set of rights with uncertain values) than Proctor (in which the donor tried to take property back). The plain language of the transfer documents showed that the taxpayer was making gifts of an ascertainable dollar value of LLC units, rather than a specified number of units. The facts also showed that the charities were advocating their own interests, not just passively helping the taxpayer reduce her tax bill. The charities conducted arm's-length negotiations, retained their own counsel, and won changes to the transfer documents to protect their interests. In addition, the directors of the charities owed fiduciary duties to their organizations to make sure that the appraisal was acceptable before signing off on the gift. Thus, the court held that (a) the formula clause was valid, (b) the sales did not result in additional gifts and (c) an additional charitable deduction was warranted for the reallocated amount passing to charity.

LIFE INSURANCE CASES

Life Insurance Proceeds Received by Limited Partnership Not Included in Gross Estate of Insured Limited Partner PLR 200947006 (Nov. 20, 2009) & PLR 200948001 (Nov. 27, 2009)

In Private Letter Rulings 200947006 & 200948001, the IRS considered whether a series of transactions among a partnership, corporations and trusts which altered the ownership and beneficiary designations of two life insurance policies required inclusion of the policies in the insured's estate.

At the outset, the partnership's sole asset was life insurance on the taxpayer's life. The general partner of the partnership was a corporation that was wholly owned by the insured. The limited partners of the partnership included the insured and a second corporation. The second corporation was owned by a trust formed by the insured's parents. The trustees were the insured and his sister. The sole current beneficiary was the insured. The insured did not have any power of appointment. Upon the insured's death, the trust assets were to pass in trust for his descendants.

The insured, the partnership, the corporations and the trusts proposed entering into a multistep transaction, which would result in the partnership still owning the life insurance; however, the partnership would be owned by the trust created by the insured's parents, plus another trust formed by the insured for the benefit of his wife and children. The insured would remain a co-trustee of the trust created by his parents, but he would release to his co-trustee/ sister all powers to make decisions with respect to the insurance. The first trust would contribute cash to the partnership in an amount estimated to cover the premiums on the policies for the rest of the insured's life.

The IRS held that policies were not includible in the insured's estate because he would hold no incidents of ownership either before or after the transactions. The IRS relied on Estate of Knipp v. Commissioner, 25 T.C. 153 (1955), in which a decedent was a 50% general partner in a partnership that owned and was the beneficiary of ten life insurance policies on the decedent's life. In Knipp, the Tax Court found that the partnership bought the policies in the ordinary course of business and that the decedent, in his individual capacity, had no incidents of ownership. Therefore, the policies were not includible in his estate. Prior to Private Letter Rulings 200947006 & 200948001, some practitioners believed that a partnership might not be able to benefit from Knipp unless there was a business purpose for holding the insurance. However, the partnerships in the Private Letter Rulings had no assets apart from the insurance, which suggests that a business purpose for ownership of the policies is not necessary.

Tax Court Finds that Value of Life Insurance Policy Sold from Profit-Sharing Plan to the Insured is Determined by Reference to the Policy's "Entire Cash Value," which Allows no Reduction for Surrender Charges, thereby Resulting in Taxable Income from Bargain Sale – Matthies v. Commissioner, 134 T.C. No. 6 (February 22, 2010)

At issue in Matthies was whether taxable income resulted from the sale of a second-to-die life insurance policy by the profit-sharing plan of the taxpayers' wholly owned subchapter S corporation to the taxpayers.

In October of 1998, the taxpayers incorporated their subchapter S corporation and formed its profit-sharing plan. In January of 1999. the plan purchased an $80 million second-to-die life insurance policy on the lives of the taxpayers. During 1999 and 2000, the taxpayers transferred over $2.5 million from an IRA to the profit-sharing plan. These contributions were used to pay the premiums on the life insurance policy. Then, in December of 2000, the profit-sharing plan sold the policy to the taxpayers for about $315,000. At the time of the sale, the "cash value" of the policy was about $306,000, but the "account value" was almost $1.4 million. The difference between the "cash value" and the "account value" was a result of a surrender charge that would be imposed upon the policy if surrendered within the three years after issuance.

The taxpayers then transferred the policy to a "family irrevocable trust." In January of 2001, the trust exchanged the policy for another survivor policy with a face amount of $19.5 million. As part of the exchange, the life insurance company waived the surrender charge and accepted the $1.4 million "account value" as full payment for the new policy.

Because the sale of the policy was not negotiated at arm's length, the Tax Court considered the proper method for valuing the policy for purposes of determining whether the taxpayer's realized taxable income from a bargain sale. In this regard, the essential question was whether the surrender charge should be taken into account in valuing the policy, or, in other words, whether fair market value of the policy was its "cash value" or its "account value." The court reviewed statutory and regulatory language from IRC Sections 72, 402 and 7702 and determined that for purposes of calculating the taxpayers' income from the bargain sale, the value of the policy should be determined without reference to the cash surrender value. Accordingly, the court held that the taxpayers recognized about $1.1 million of taxable income from the transaction. However, in light of ambiguity as to the proper tax treatment of the transaction, the court declined to assess a negligence penalty against the taxpayers.

Tax Court Finds that Termination of Variable Life Insurance Policy against which Taxpayer had Borrowed Did Not Result in Cancellation of Indebtedness Income, but rather in Taxable Distribution of the Policy's Cash Surrender Value – McGowen v. Commissioner, T.C. Memo 2009285 (December 14, 2009)

In McGowen v. Commissioner, the Tax Court found that the termination of a variable life insurance policy resulted in a taxable distribution of the policy's cash surrender value. From 1989 until the termination of the policy in 2003, the taxpayer continually borrowed against the cash surrender value of her variable life insurance policy. As the debt against the policy grew, together with accrued interest, the life insurance company terminated the policy and used its cash surrender value to satisfy the taxpayer's debt. The insurance company issued the taxpayer a 1099 reporting about $565,000 in income

At issue was the characterization of the income. The taxpayer argued that the income was a result of cancellation of indebtedness. Characterization as such would have permitted the taxpayer to avail herself of the provisions of IRC Section 108 and exclude the amount from gross income. However, the Tax Court disagreed with this characterization. The court found that the debt was not extinguished; rather, the insurance company had applied the cash surrender value of the policy against the debt. This constituted an indirect distribution under IRC Section 72. Accordingly, the taxpayer was not entitled to an exclusion from gross income.