Significant Recent Developments in Estate Planning (Part I)

By Justin Ransome, J.D., MBA, CPA, and Frances Schafer, J.D.

EXECUTIVE
SUMMARY

  • The Tax Relief Act of 2010 reinstated the estate tax and the generation-skipping transfer tax, set the maximum tax rate for the estate, gift, and generation-skipping transfer taxes at 35%, and increased the gift and estate tax exemption amount to $5 million. The legislation also made the estate exemption portable between spouses.
  • In Estate of Keller, a district court held that whether property was “property subject to claims” for purposes of Sec. 2053(c)(2) did not depend on whether the property was part of the decedent’s probate estate.
  • In Estate of Saunders, the Tax Court discussed the difference between valuing an asset and valuing a liability in a decedent’s estate.

This two-part article examines developments in estate, gift, and generation-skipping tax planning and compliance between June 2010 and May 2011. It discusses legislative developments, the outlook on estate tax reform, cases and rulings, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (Tax Relief Act), 1 and the annual inflation adjustments for 2011 relevant to estate and gift tax. Part I discusses estate tax reform, cases and rulings, the Tax Relief Act, and other estate tax developments. Part II, in the October issue, will cover gift tax, generation-skipping transfer tax, and trust developments.

Estate Tax Reform

On December 17, 2010, President Barack Obama signed into law the Tax Relief Act, which includes extensions of 2001 and 2003 income tax cuts, individual alternative minimum tax relief, estate tax relief, unemployment relief, and certain other temporary tax provisions. Most of the provisions in the Tax Relief Act are temporary, and the transfer tax provisions expire on December 31, 2012.

In general, the Tax Relief Act reunifies the gift and estate tax; increases the gift and estate tax exemption amount to $5 million; provides for a top gift, estate, and generation-skipping transfer (GST) tax rate of 35%; provides an election for estates of decedents dying in 2010 to choose to apply the estate tax law applicable in 2010 prior to the enactment of the Tax Relief Act; allows portability between spouses of their estate tax exemption amounts; and preserves the taxpayer-favorable GST tax rules contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). 2 (See the exhibit.)

Gift Tax

Top rate: The Tax Relief Act resets the gift tax rate schedule to mirror the estate tax rate schedule with a top rate of 35%. This provision was effective on January 1, 2011.

Exemption amount: The exemption amount for both gift and estate tax was the same, or unified, prior to EGTRRA. Under EGTRRA, gift and estate taxes were decoupled as the estate tax exemption amount steadily increased over several years, while the gift tax exemption amount remained at $1 million. The Tax Relief Act reunifies the gift and estate tax exemption amounts by amending Sec. 2505 to provide that the gift tax exemption is the same as the estate tax exemption. This provision was effective on January 1, 2011, at which time the estate tax exemption amount was $5 million.

Estate Tax

Repeal of carryover basis: The Tax Relief Act repeals the provisions in EGTRRA that had repealed the estate tax in 2010 and provided for modified carryover basis. This provision was effective on January 1, 2010. Thus, as discussed below, any person dying in 2010 with an estate in excess of $5 million was subject to estate tax at 35%.

The Tax Relief Act, however, gives the estate of a person dying in 2010 an election to apply the law as if the act had not repealed the provisions in EGTRRA. This provision allows the estates of decedents in 2010 to elect to have no estate tax imposed but also requires the use of carryover basis. Treasury is delegated the authority to determine the time and manner in which the election is to be made.

The Tax Relief Act essentially retroactively reinstates the estate tax to apply to estates of decedents dying in 2010. In general, if a person died in 2010 and the estate was less than $5 million, the estate does not owe estate tax and receives a step-up in basis of the assets in the estate to their fair market value (FMV) at the date of the decedent’s death. If a person died in 2010 and the estate was in excess of $5 million, the estate may want to elect to apply the law in effect before enactment of the act. If it makes the election, the estate does not pay estate tax and applies the carryover basis rules set forth in EGTRRA.

The lateness of the passage of the Tax Relief Act provides additional time for the estates of decedents who died in 2010 (before December 17, 2010) to file an estate tax return, pay estate tax, or make a qualified disclaimer. The additional time is nine months from the date of enactment, December 17, 2010.

Top rate: The Tax Relief Act sets the top estate tax rate at 35%. The lower rates, however, continue to be in effect for the first $500,000 of an estate and are used in the calculation of the estate tax for an estate in excess of $5 million (i.e., above the estate tax exemption amount).

Exemption amount: The Tax Relief Act sets the estate tax exemption amount (otherwise referred to as the applicable exclusion amount) at $5 million, and this amount is indexed for inflation in $10,000 increments after 2011. This provision was effective on January 1, 2010.

Portability: The Tax Relief Act provides for portability of the estate tax exemption amount between spouses. This allows a surviving spouse to utilize the unused estate tax exemption amount of the first-to-die spouse. For a surviving spouse to use the deceased spouse’s unused estate tax exemption amount, the executor of the deceased spouse’s estate must file an estate tax return that computes the unused estate tax exemption amount and makes an election on the return that allows the surviving spouse to use the deceased spouse’s unused estate tax exemption amount. This provision is effective if the first spouse dies on or after January 1, 2011, and the second spouse dies or makes gifts before January 1, 2013.

GST Tax

Reinstatement of GST tax: The Tax Relief Act repeals the provisions of EGTRRA that had repealed the GST tax for 2010. This provision was effective on January 1, 2010. Thus, GST tax applies to GSTs (i.e., direct skips, taxable terminations, or taxable distributions) that occurred in 2010. However, for GSTs that occurred in 2010, the applicable rate under Sec. 2641(a) is zero.

The Tax Relief Act essentially retroactively reinstates the GST tax to apply to GSTs occurring in 2010. Thus, if a donor transferred $10 million to a trust for the benefit of grandchildren (i.e., skip persons), the transfer was a direct skip and has GST tax consequences. However, the applicable rate to apply to the GST is zero, and no GST tax would be due.

Direct skips have GST exemption automatically allocated to them, and an election out of these automatic allocation rules needed to be made on timely filed gift tax returns for 2010 to preserve GST exemption for future years. If this election out is made, the trust has an inclusion ratio of one.

Example: On December 1, 2010, G transferred $10 million to a trust for the benefit of her grandchildren and great-grandchildren. She elected on her Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, not to allocate GST exemption to the transfer. The GST tax that G paid on the direct skip is zero, because the applicable rate is zero. The trust, however, is not exempt from GST tax because it has an inclusion ratio of one. Under the “move down” rule in Sec. 2653(a), G is assigned to the generation above the highest generation in the trust—i.e., to the generation of the parents of the grandchildren. Distributions from the trust to grandchildren will not be subject to GST tax because, under Sec. 2653(a), they are only one generation below G’s generational assignment. However, transfers to great-grandchildren will be subject to GST tax because they are two generations below G’s generational assignment.

Because of the lateness of the passage of the Tax Relief Act, it also provides additional time for persons who made GSTs prior to the date of enactment to file a return for GST tax purposes. The additional time is nine months from the date of enactment. Thus, for taxable distributions or taxable terminations occurring between January 1, 2010, and December 16, 2010, the due date for Forms 706-GS(T), Generation-Skipping Transfer Tax Return for 2010 Terminations, 706-GS(D), Generation-Skipping Transfer Tax Return for 2010 Distributions, and 706-GS(D-1), Notification of Distribution from a Generation-Skipping Trust, is September 19, 2011. For taxable distributions or taxable terminations occurring on or after December 17, 2010, the due date for those forms was April 18, 2011.

Top rate/exemption amount: Sec. 2641 sets the GST tax rate at the highest estate tax rate. The top estate tax rate under the Tax Relief Act is 35%, so the GST tax rate is 35%. Sec. 2631(c) sets the GST exemption amount at the estate tax exemption amount. The estate tax exemption amount under the act is $5 million, so the GST exemption amount is $5 million, indexed for inflation after 2011.

The Tax Relief Act further lifts the sunset provisions in EGTRRA on the automatic allocation of GST exemption to certain transfers and Sec. 9100 relief. Thus, these provisions continue to be applicable under the act.

Estate Tax

Estate Tax Inclusion

Estate of Stewart: In Estate of Stewart, 3 the Second Circuit remanded the case to the Tax Court to determine the proper portion of a transferred interest to be included in the decedent’s gross estate under Sec. 2036. The Tax Court had held that, after the decedent transferred a 49% interest in a New York brownstone to her son, there was an implied agreement that the decedent would retain the economic benefits from the brownstone; therefore, the entire transferred interest was includible in her gross estate under Sec. 2036. At dispute in essence was the value of the discounts available for a gift of a partial interest in real estate as well as inclusion of a partial interest in the property (the taxpayer’s position) versus the inclusion of the entire interest in the decedent’s gross estate with no discounts (the IRS’s position).

In general, Sec. 2036(a)(1) includes in a decedent’s gross estate for estate tax purposes the value of transfers made by a decedent during his or her lifetime when the decedent has retained certain rights with regard to the possession of, enjoyment of, or income from the transferred property. Sec. 2036(a) contains an exception to its application if the transfer is a bona fide sale for adequate and full consideration in money or money’s worth (the bona fide sale exception).

The decedent and her son lived in the bottom two floors of the brownstone, and they rented the top three floors to a company. About six months before her death, Stewart transferred a 49% interest in the brownstone to her son. She and her son continued to live there until her death, and she continued to receive all the rental income from the tenants.

The Second Circuit concluded that because the decedent did not use the residential portion of the brownstone exclusively and did not exclude her son from using that portion, the decedent’s continued use of that portion did not indicate that there was an implied agreement with regard to the residential portion of the son’s 49% interest. Because all the rental payments from the commercial portion of the brownstone continued to go to the decedent, it was not clearly erroneous for the Tax Court to find that there was an implied agreement, but it was clearly erroneous to find that the implied agreement covered 100% of the son’s 49% interest, since the son enjoyed the benefits of the residential portion of his 49% interest.

The Second Circuit remanded the case to the Tax Court to determine the portion of the transferred property over which the decedent retained an interest. According to the court, that determination should be made by applying the principle that the portion of the property to be included in the decedent’s gross estate is the portion that would be necessary to produce the net income that the decedent retained.

Estate of Riese: In Estate of Riese, 4 the decedent created a valid three-year qualified principal residence trust (QPRT), with the residence passing to two trusts for the benefit of her daughters upon expiration of the QPRT. Most of the planning with regard to the QPRT was handled through the daughters, who held powers of attorney for the decedent. However, the decedent was involved in the planning process and was advised on the planning periodically through her estate planning attorney, who explained to her that upon the expiration of the QPRT, she would no longer own the residence and would be required to pay fair value rent if she decided to remain in the residence.

Upon expiration of the QPRT, the QPRT’s trustee did not immediately execute a deed transferring the residence to the daughters’ trusts. The decedent’s daughters never discussed rent directly with Riese after the QPRT terminated. However, one of the daughters contacted the estate planning attorney to ask about the proper amount of rent to charge the decedent. The attorney explained that fair value rent could be determined by contacting local real estate brokers and that this could be done by the end of the calendar year (the QPRT expired in April).

In October of the year in which the QPRT expired, Riese suffered a stroke and died unexpectedly; she had continued to live in the residence until she died. During the six-month period from the QPRT’s termination until the decedent’s death, Riese continued to pay all the property taxes, insurance, upkeep, and maintenance on the residence. She did not pay rent or execute a written lease or rental agreement. After her death, the decedent’s estate assumed responsibility for and paid all property taxes, insurance, upkeep, and maintenance on the residence until the estate sold the residence a year later. The daughters’ trusts did not maintain homeowner’s insurance for the residence or directly pay any of the foregoing expenses.

The decedent’s estate did not include the value of the residence in its gross estate. The estate further claimed as a deduction under Sec. 2053 a debt of $46,298 owed to the daughters’ trusts for the net fair market rent of $7,500 per month from the date the QPRT expired until the decedent’s death. The IRS included the value of the residence in the decedent’s gross estate under Sec. 2036, determining that there was an implied agreement between the decedent and the daughters’ trusts that the decedent would continue to enjoy the use of the residence after the expiration of the QPRT without paying rent.

After reviewing prior case law on the subject and all the evidence, the Tax Court determined that as a matter of fact, there was an agreement among the parties for Riese to pay fair value rent, the amount of which was to be determined, and to begin payment by the end of the calendar year in which Riese died. The court noted that the existence of an implied agreement was negated by the express agreement among the parties for the payment of rent. The court listed the following factors as determinative of its decision that there was no agreement or understanding that the decedent would retain an interest in the residence for life without paying rent:

  • The creation of the QPRT;
  • The payment of gift tax upon the transfer of the residence to the QPRT;
  • Several instances in which the decedent agreed to pay rent;
  • The fact that one of the daughters called the decedent’s attorney upon the termination of the QPRT to find out how to determine the amount of rent to charge; and
  • The corroborating testimony of the decedent’s estate planning attorney.

Therefore, the court ruled that the residence was not includible in the decedent’s gross estate. Having made such a determination, the court further determined that the estate was entitled to deduct the accrued rent owed to the daughters’ trusts by the decedent from the date the QPRT expired until the decedent’s death.

While the taxpayer was successful in this case, evidence of the intent to rent may not be present in every situation. A possible solution is to include in the trust agreement an option for the parent to rent the house at fair rental value as soon as the parent’s occupancy rights under the QPRT expire. The parent would exercise the option to rent by delivering written notice to the trustee exercising the option. However, if the parent remains in possession of the residence beyond the expiration of the QPRT term or beyond the end of any other period of time (such as the term of a prior lease with the trust), such continued occupancy by the parent is deemed an exercise of the parent’s option to rent, and the trustee is entitled to rent. This option should eliminate any Sec. 2036 argument if the parent dies shortly after the QPRT term expires and before the lease agreement can be put into place.

Claims Against Estate

Under Sec. 2053(a), the value of a taxable estate is determined by deducting amounts (such as funeral and administration expenses) from the value of the gross estate. Sec. 2053(a)(3) allows a deduction for claims against a decedent’s estate. There were a number of cases over the past year originating from the IRS’s disallowance of deductions for claims against the estate.

Keller: In Keller, 5 a district court was asked to determine whether property subject to claims for purposes of Sec. 2053(a)(3) must be part of the probate estate. The IRS challenged several items of claimed deductions, the most significant of which was for items that were paid on behalf of the estate after the period of limitations on assessments had expired. The government’s challenge was based on the limitation in Sec. 2053(b), which provides that expenses incurred in administering property not subject to claims that is included in the gross estate are deductible to the same extent such amounts would be allowable as a deduction if the property were subject to claims, provided the expenses are paid before the expiration of the period of limitation for assessment provided in Sec. 6501. The IRS argued that property “not subject to claims” is generally property that passes outside the probate estate. Most of the assets subject to estate tax in the decedent’s estate were held either in a marital trust established on the death of the decedent’s spouse or in the decedent’s revocable trust, neither of which was subject to probate upon the decedent’s death.

Sec. 2053(c)(2) provides that the term “property subject to claims” means property includible in the decedent’s gross estate that would bear the burden of payment of such deductions in the final adjustment and settlement of the estate. The district court rejected the government’s argument that whether property is subject to claims depends on whether the property is part of the probate estate. Instead the court looked to whether the assets in the trusts bore the burden of the claimed deductions. It examined the terms of the decedent’s will, which mandated the payment of all debts, administration expenses, and estate taxes from either the residuary estate or the family trust (to be apportioned under the terms of the trust between the marital trust and the revocable trust). The Texas statute requires executors to pay administrative expenses and estate taxes in accordance with the terms of the decedent’s trust or will. 6 Based on the provisions of the will and the trust agreement, the court concluded that the two trusts would bear the burden of the payment of these expenses under Texas law, and therefore the expenses paid after the expiration of the statute of limitation are deductible.

Estate of Shapiro: In Estate of Shapiro, 7 the Ninth Circuit reversed and remanded a case back to the district court to determine the value of a palimony claim as of the date of the decedent’s death. The estate had tried to deduct the claim on an amended estate tax return as a claim against the estate under Sec. 2053(a).

Cora Chenchark and Bernard Shapiro lived together in Nevada for 22 years. After they broke up, Cora sued Bernard for palimony, claiming that they had agreed to share their assets equally. While the suit was pending, Bernard died. His estate ultimately settled Cora’s claim by transferring $1 million to her. After the settlement, the estate filed a claim for refund of estate tax, claiming a deduction for Cora’s claim valued at $8 million as of the date of Bernard’s death. The IRS disallowed the claim.

The district court granted the government’s motion for summary judgment and disallowed the claim based on the court’s conclusion that under Nevada law love, emotional support, and managing the household employees do not constitute consideration to support a contractual arrangement. On appeal, the Ninth Circuit concluded that the district court had incorrectly interpreted Nevada law. While the Nevada Supreme Court has never addressed the issue, the highest courts in California and Arizona have held that homemaking services can be adequate consideration for property-sharing arrangements between cohabitants. The Ninth Circuit concluded that Nevada would follow the rule of these two states.

The government had argued that the claim was not deductible because it was not supported by adequate and full consideration. The district court never reached this issue because it concluded as a matter of law that homemaking services cannot provide consideration. The Ninth Circuit remanded the case to determine the value of the homemaking services, which under its interpretation of Nevada law would provide consideration for a contractual arrangement. The Ninth Circuit noted that if the district court determined that the claim was supported by adequate and full consideration, the amount of the deduction would be based on the value of the claim at the date of the decedent’s death, not taking into consideration post-death events.

Prior to 2009, neither Sec. 2053(a) nor the Treasury regulations thereunder contained a method for valuing a claim against an estate for estate tax purposes, and there was little consistency among the courts regarding the extent to which post-death events should be considered in valuing such claims. In general, the court decisions floated between one line of cases that follows a date-of-death valuation approach and another line of cases that restricts deductible amounts to those amounts actually paid by the estate in satisfaction of the claim. The Ninth Circuit requires the date-of-death valuation approach.

In 2009, the IRS issued regulations under Sec. 2053 that reflect the rejection of the date-of-death valuation approach and adopt rules based on the premise that an estate may deduct only amounts actually paid in settlement of claims against the estate. The regulations “clarify” that events occurring after a decedent’s death are to be considered when determining the amount deductible under all provisions of Sec. 2053 and that such deductions are limited to amounts actually paid by the estate in satisfaction of deductible expenses and claims. These regulations are effective for decedents who die on or after October 20, 2009.

Marshall Naify Revocable Trust: In Marshall Naify Revocable Trust, 8 the decedent’s estate sought a refund of estate taxes based on the estimated value of the decedent’s contested California income tax liability at the time of his death. A deduction had been allowed on his federal estate tax return for the actual amount paid to California ($26 million), but the estate believed it was entitled to deduct the estimated date-of-death value of the claim ($47 million). Interestingly, the contested liability resulted from the decedent’s position that his corporation was an S corporation for federal income tax purposes but a C corporation located in Nevada for California income tax purposes. The California taxing authority did not agree.

While the district court noted the existence of the new Sec. 2053 regulations in a footnote, it did not address their impact as providing “interpretative guidance” because it agreed with the government’s position based on the pre-amendment state of the law. The district court examined whether the value of the disputed claim was ascertainable with reasonable certainty at the date of the decedent’s death. Prior to death, the decedent and his associates were making considerable efforts to establish that the corporation was a Nevada C corporation, and its income would not be taxable to the California resident decedent. The court noted that in order for the estate to have any income tax liability as of the time of the decedent’s death, a number of steps would have to occur after the decedent’s death (including an actual audit of the return and a finding that the corporation was not a Nevada corporation).

Under these facts, the court concluded that any estimate of the claim’s value as of the decedent’s death was inherently uncertain. The court also concluded that even if the claim’s value were reasonably certain, it was not clear at the date of death that it would be paid. Finally, the court noted that the precedent in the Ninth Circuit was to consider post-death events in assessing the value of the claim. As a result, the estate was not entitled to a deduction for the estimated value of the claim.

The Tax Court was also called upon to determine the value of claims against the estate in two cases. In both cases, it determined that the claims were not ascertainable with reasonable certainty, and thus the claims were not deductible in determining the decedent’s taxable estate.

Estate of Saunders: In Estate of Saunders, 9 the decedent’s estate had a pending claim against it stemming from a malpractice suit against the decedent’s previously deceased spouse. The suit claimed damages of $90 million. The estate valued the malpractice claim at $30 million based on an appraisal by the attorney handling the malpractice suit for the decedent’s estate. The claim was ultimately settled for $250,000. The IRS challenged the valuation and allowed a deduction of $1. The estate later obtained two additional valuations of the malpractice claim, which valued the claim at $19,300,000 and $22,500,000.

The Tax Court discussed the difference between valuing an asset versus valuing a liability in the decedent’s estate. A claim that is an asset in the estate can be valued using recognized methods by assuming various outcomes, assigning probabilities to those outcomes, and quantifying the results. A stricter valuation standard is applicable for a claim that is a liability of the estate because of the regulatory requirement that the claim must be “ascertainable with reasonable certainty.” The Tax Court noted that the appraisals from the three different experts varied widely in methodology and in valuation of the claim and did not opine as to whether the valued amount would actually be paid. The Tax Court concluded that the claim was not ascertainable with reasonable certainty and would be deductible only when actually paid. As a result, the $30 million deduction claimed on the estate tax return was reduced to the $250,000 amount actually paid plus the $289,000 cost of litigation.

Estate of Foster: In Estate of Foster, 10 litigation against the decedent had been decided in favor of the decedent prior to her death, but an appeal of that decision was pending at the time of her death. The decedent’s estate discounted the assets of the marital trusts created by her previously deceased spouse and included in her estate 29% (approximately $14.7 million) attributable to the pending appeal. The plaintiffs in the litigation claim ultimately released the decedent’s estate from the claim. The decedent’s estate did not include the value of possible claims the estate may have had against the trustee of the marital trusts for breach of fiduciary duty and the attorney who drafted agreements related to the creation of an employee stock option agreement. The decedent’s estate settled its claims against the attorney for $850,000, and a jury awarded the decedent’s estate $17 million in its suit against the trustee.

The IRS disallowed the discount regarding the marital trusts because the litigation claim against it was not a “sum certain” and was not “legally enforceable” at death. Alternatively, the IRS claimed the discount was a vague and uncertain estimate that was not reasonably certain. The IRS did not assert a deficiency for the claims the estate held against the attorney or the trustee; however, it later asserted a deficiency of $5.1 million regarding the estate’s claim against the trustees in pleadings filed prior to trial. The decedent’s estate submitted a valuation of the claim against the trustees of $33,000.

The Tax Court did not take into consideration any litigation discount or deduction under the same theory as applied in the Estate of Saunders case—i.e., the value was not established with reasonable certainty. With regard to the value of claims held by the estate, the Tax Court considered the methodology used by experts for both sides, made adjustments to the computations, and arrived at a value of $930,000. The costs of the estate’s actual litigation expenses were deducted separately.

Charitable Deduction

In general, Sec. 2055 allows an estate a deduction for bequests to charitable organizations. The issue before the district court in Estate of Palumbo 11 was whether an agreement settling a will contest and making a transfer to a charitable trust entitled the estate to an estate tax charitable deduction.

During his life, Palumbo had established a charitable trust. Over the years, he had executed various wills leaving the residue of his estate to the charitable trust. However, in the last will he executed that was admitted to probate, no residuary beneficiary was named. Due to the lack of a residuary beneficiary in the decedent’s will, his son filed a claim in the probate proceedings that the decedent’s residuary estate fell into intestacy. The son claimed that he was entitled to the residue of the estate as the sole heir under the state’s intestacy law. The charitable trust, however, claimed that it was entitled to the residue of the decedent’s estate because the missing clause in the will admitted to probate was due to a scrivener’s error (an error by the drafter of the will). The attorney who drafted the will admitted to probate conceded that the failure to name the charitable trust as the residuary beneficiary was a scrivener’s error. The charitable trust and the decedent’s son eventually reached a settlement agreement that was agreed to by all the parties and the state’s attorney general. Under the terms of the settlement agreement, the charitable trust received approximately $12 million.

In determining its estate tax liability, the estate deducted the residue of the decedent’s estate passing to the charitable trust. The IRS disallowed the charitable deduction, determining that it was the decedent’s son (via the settlement agreement) that made the transfer to the charitable trust, not the decedent pursuant to his will.

The first issue before the district court was whether Sec. 2055 could be interpreted to allow a deduction where a decedent’s will had not specifically provided for a bequest to a charity but such transfer was made under a settlement agreement. The IRS cited Estate of Bosch, 12 which strictly construed the marital deduction statute (Sec. 2056) to curtail marital deduction abuses, finding that Congress used very guarded language referring to the issue present in Estate of Bosch. After reviewing the legislative history of Secs. 2055 and 2056, the court determined that the two sections could be construed differently based on congressional intent and declined to narrowly construe Sec. 2055. The court therefore ruled that Estate of Bosch did not apply in the present case where the legislative intent behind Sec. 2055 is to encourage charitable gifts.

The IRS next argued that because the charitable trust had no legally enforceable right to the residue under state law, there was no bona fide dispute between the parties. Therefore, the settlement agreement was in the nature of a gift by the decedent’s son to the charitable trust. The district court noted that the decedent repeatedly manifested his intent to leave the residue of his estate to the charitable trust, as evidenced by earlier iterations of his will and other evidence presented to the court. The court further noted that the decedent’s attorney had acknowledged committing a scrivener’s error in drafting the decedent’s will admitted to probate, specifically noting that he failed to include a provision concerning the residuary estate. Citing prior precedent, state law, and the abundant evidence that the decedent intended for the charitable trust to receive the residue of his estate and that the settlement agreement was the settlement of a bona fide dispute between the decedent’s son and the charitable trust, the court ruled that the decedent’s estate was entitled to a deduction under Sec. 2055 for the amount passing to the charitable trust under the settlement agreement.

This case is another example of the cost of carelessness. Luckily for the estate (and the estate’s attorney, although the facts indicate that the estate sued him for malpractice), the district court found that state jurisprudence supported a long-standing policy that:

  • When a person prepares a will, it is presumed that the person intended to dispose of the entirety of the estate and not die intestate as to any portion of it; and
  • If possible, a will must be construed to avoid intestacy.

Here, the district court was willing to look outside the four corners of the will and allow other evidence to support the long-standing state law policy.

Valuation

In Estate of Jensen, 13 the Tax Court returned to its present value concept to determine the discount for built-in capital gains tax when valuing an interest in an entity for estate tax purposes. The discount for built-in capital gains tax is founded upon the premise that a hypothetical buyer, in determining the price he or she would pay for an interest in an entity, would take into consideration the tax on the capital gain inherent in an entity whose assets’ FMV meaningfully exceeds its tax basis compared with an entity whose assets’ FMV approximates its tax basis. The discount is applicable when the best estimate of an entity’s value is based upon the asset approach to valuation.

The Tax Court held that the value of the corporation, which consisted of real estate and improvements used to operate a summer camp for girls, should be reduced by the present value of the tax on the built-in capital gain. The present value was determined by calculating the future value of the assets in the corporation using two different rates of appreciation over 17 years (the average useful life for the real estate and its improvements), calculating the federal and state tax if the property were sold then, and present valuing the tax obligation using the same rates used to calculate appreciation. The result in this case was slightly greater than what the estate claimed was the full amount of capital gain tax that would have been imposed if the property had been immediately sold.

The Tax Court had used a somewhat similar approach in Estate of Jelke 14 prior to being overruled by the Eleventh Circuit. In valuing stock in a closely held, subchapter C corporation whose assets were primarily securities, the court determined the present value using the asset turnover ratio the corporation had used in managing its assets over the years prior to the decedent’s death. The court determined that it would take 16 years to fully turn over the portfolio held by the corporation and that the present value of the 16 tax payments amounted to the built-in gains discount. The Tax Court refused to consider appreciation in the value of the assets over time. The Eleventh Circuit rejected the Tax Court’s valuation method for determining the built-in gains tax as being too speculative about the corporation’s future investment activities. Instead, the court chose to follow the decision of the Fifth Circuit in Estate of Dunn 15 and ruled that it is more logical and appropriate to determine the built-in gains tax as if the corporation had liquidated on the date of the decedent’s death without resort to present values or prophesies.

The Tax Court in Estate of Jensen stuck to its actuarial concept but allowed for the appreciation in the assets’ valuation at the same interest rate that is used to discount the future tax obligation to its present value. If appreciation in the assets is considered and the same interest rates are used, it seems that the present value of the capital gains tax should be close to the full value of the capital gains tax computed as if all the assets were sold at the date of the decedent’s death. It is unclear why there was a need to go through the calculations in Estate of Jensen when the courts in Estate of Jelke and Estate of Dunn reached essentially the same result.

Estate Tax Credit

Estate of Le Caer 16 addresses the application of the credit for tax on prior transfers under Sec. 2013. This section allows the estate of an individual who received property that was subject to estate tax upon the death of a prior decedent to receive a credit for some of the estate tax previously paid if the two deaths occur within 10 years.

In this case, the husband died three months before the wife. Part of the husband’s estate passed to a family trust to use the estate tax applicable exclusion amount, part to a trust for which a QTIP election was made, and part to a trust for which no QTIP election was made even though the wife was to receive an income interest for life with a limited right to invade principal. On the wife’s estate tax return, the estate claimed a credit under Sec. 2013 for the entire amount of the federal and state estate taxes paid on the husband’s return.

The wife’s estate contended that based on Sec. 2013(a) the estate is entitled to a full credit for the amount of taxes paid and ignored the limitations imposed by Secs. 2013(b) and 2013(c) because only the property passing to the wife not in the QTIP trust generated estate tax. Secs. 2013(b) and 2013(c) provide that the amount of the credit is the lesser of the amount of the federal estate tax attributable to the transferred property in the transferor’s estate and the amount of the federal estate tax attributable to the transferred property in the decedent’s estate.

The Tax Court agreed with the IRS that the amount of the credit is computed under Secs. 2013(b) and 2013(c). Because the amount passing to the wife outside the QTIP trust and the property in the family trust were both part of the husband’s taxable estate and thus were subject to estate tax, his estate tax was only partially attributable to the property passing to the wife, and the credit was available for only her proportionate share.

The estate also argued that the credit should include the Nevada estate tax because it was like a pick-up tax. Even though the Nevada estate tax was computed based on the maximum amount of the state death tax credit available on federal returns at that time, the tax was imposed by the state of Nevada. Thus, the Tax Court concluded that the state estate tax was not a federal estate tax credible under Sec. 2013, regardless of how it was computed.

Footnotes

1 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, P.L. 111-312.

2 Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

3 Estate of Stewart, 617 F.3d 148 (2d Cir. 2010).

4 Estate of Riese, T.C. Memo. 2011-60.

5 Keller, No. 6:02-cv-00062 (S.D. Tex. 9/14/10).

6 TX Prob. Code Ann. §322A(b)(2).

7 Estate of Shapiro, 634 F.3d 1055 (9th Cir. 2011).

8 Marshall Naify Revocable Trust, No. C 09-1604 CRB (N.D. Cal. 9/8/10).

9 Estate of Saunders, 136 T.C. No. 18 (2011).

10 Estate of Foster, T.C. Memo. 2011-95.

11 Estate of Palumbo, No. 2:10-cv-00760 (W.D. Penn. 3/9/11).

12 Estate of Bosch, 387 U.S. 456 (1967).

13 Estate of Jensen, T.C. Memo. 2010-182.

14 Estate of Jelke, T.C. Memo. 2005-131, rev’d, 507 F.3d 1317 (11th Cir. 2007).

15 Estate of Dunn, 301 F.3d 339 (5th Cir. 2002).

16 Estate of Le Caer, 135 T.C. No. 14 (2010).

EditorNotes

Justin Ransome is a partner and Frances Schafer is executive director in the National Tax Office of Grant Thornton LLP in Washington, DC. For more information about this article, contact Mr. Ransome at justin.ransome@us.gt.com or Ms. Schafer at frances.schafer@us.gt.com.

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