Estates, Trusts & Gifts
In a departure from its own precedent, the Tax Court held that the fair market value (FMV) of a donor’s taxable gift may be determined with reference to the donee’s assumption of the potential Sec. 2035(b) estate tax liability for the gift.
On April 17, 2007, Jean Steinberg, a resident of New York, entered into a binding gift agreement (net gift agreement) with her four adult daughters. At that time Steinberg was 89 years old. In the net gift agreement she agreed to make gifts of cash and securities to her daughters. In exchange, they agreed to assume and to pay any federal gift tax liability imposed as a result of the gifts. The daughters also agreed to assume and to pay any federal or state estate tax liability imposed under Sec. 2035(b) as a result of the gifts in the event that Steinberg passed away within three years of the gifts. The net gift agreement was the result of several months of negotiation between Steinberg and her daughters, who were represented by separate counsel.
Steinberg retained an appraiser to calculate the gross FMV of the property transferred. The appraiser also calculated the aggregate FMV of the “net gift.” The appraiser determined the value of the net gift by reducing the FMV of the cash and securities by both (1) the gift tax the daughters paid and (2) the actuarial value of their assumption of the potential Sec. 2035(b) tax liability. The appraiser determined the actuarial value of the daughters’ assumption of the potential Sec. 2035(b) tax liability by calculating Steinberg’s annual mortality rate for the three years after the gift (i.e., the probability that Steinberg would die within one year, two years, or three years of the gift), among other things. The appraiser determined that the aggregate FMV of the net gift was $71,598,056, as of the date of the gift. Steinberg valued her daughters’ assumption of the potential Sec. 2035(b) tax liability at $5,838,540.
On Oct. 15, 2008, Steinberg timely filed a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for tax year 2007. On the Form 709, Steinberg reported taxable gifts of $71,598,056 and total gift tax of $32,034,311. Steinberg attached a summary of the net gift agreement, which included a description of the appraiser’s determination of the value of the net gifts, to the Form 709.
On July 25, 2011, the IRS mailed the notice of deficiency, which increased the aggregate value of Steinberg’s net gifts to her daughters from $71,598,056 to $75,608,963, for a total gift tax increase of $1,804,908. The IRS disallowed the discount Steinberg made for her daughters’ assumption of the potential Sec. 2035(b) tax liability. In response, Steinberg filed a petition in Tax Court contesting the IRS’s determination, and the IRS filed a motion for summary judgment.
When a donor makes a gift subject to the condition that the donee pay the resulting gift tax, the gift amount is reduced by the amount of the gift tax. This commonly is called a net gift. The net gift rationale flows from the basic premise that the gift tax applies to transfers of property only to the extent that the value of the property transferred exceeds the value in money or money’s worth of any consideration received in exchange therefor. The donor reduces the gift’s value by the amount of the tax because the donor has received consideration for a part of the gift equal to the amount of the applicable gift tax. In Steinberg’s case, the net gift was determined by deducting the value of both the gift tax and the potential Sec. 2035(b) tax Steinberg’s daughters agreed to pay.
Under Sec. 2035(b), a decedent’s gross estate is increased by the amount of any gift tax paid by the decedent or the decedent’s estate on any gift made by the decedent during the three-year period preceding the decedent’s death. The gift tax paid by the decedent or the decedent’s estate during the relevant three-year period includes gift tax attributable to a net gift the decedent made during that period (despite the fact that the donee is responsible for paying the gift tax in such a situation). Congress imposed the gross-up provision on gift tax paid within three years of death because the gift tax paid on a lifetime transfer that is included in a decedent’s gross estate is taken into account both as a credit against the estate tax and also as a reduction in the estate tax base, and therefore substantial tax savings can be derived under present law by making deathbed gifts even though the transfer is subject to both taxes.
Consideration and Estate Depletion Theory
As noted above, a donor need only pay gift tax on a transfer to the extent that the value of the property transferred exceeds the value of any consideration in money or money’s worth that the donor receives in exchange. To qualify as consideration in money or money’s worth, the consideration received must be reducible to value in money or money’s worth. A transfer made during the ordinary course of business, however, is per se made for consideration in money or money’s worth and thus is not subject to gift tax.
The estate depletion theory of gift tax can be applied to determine what constitutes consideration in money or money’s worth. Under this theory, a donor receives consideration in money or money’s worth only to the extent that the donor’s estate has been replenished. The benefit to the donor in money or money’s worth, rather than the detriment to the donee, determines the existence and amount of any consideration offset in the context of an otherwise gratuitous transfer.
The IRS’s Argument
The IRS claimed that the assumption of the potential Sec. 2035(b) estate tax by Steinberg’s daughters was worthless. In particular, the IRS contended that their assumption provided no benefit (monetary or otherwise) to Steinberg other than some peace of mind and that their assumption thus failed to replenish Steinberg’s estate and consequently failed as consideration for a gift under the estate depletion theory of gift tax. The IRS based its claims in part on the Tax Court’s holding in McCord, 120 T.C. 358 (2003), rev’d and remanded sub nom. Succession of McCord, 461 F.3d 614 (5th Cir. 2006). The IRS further argued that Steinberg’s daughters’ assumption of the Sec. 2035(b) tax liability was itself a gift because it was a transfer among family members and was not in the ordinary course of business.
McCord and Succession of McCord
In McCord, the taxpayers gave their sons interests in a limited partnership. The sons agreed to be liable for all transfer taxes imposed on the taxpayers as a result of the gifts. The taxpayers reduced the gross value of their gifts for the amount of gift tax generated by the gifts and the actuarially determined value of the sons’ contingent obligation to pay any estate tax that might result under Sec. 2035(b). The IRS disallowed the reduction for Sec. 2035(b) because before the death of the donor, the amount of the estate tax related to the gift was too speculative. The Tax Court also stated that the reduction of the gift’s value failed under the estate depletion theory because the value of the sons’ paying the Sec. 2035(b) tax would accrue to the estate, not to the donor, and thus there would be not be the benefit to the donor that is required to invoke the net gift principle. However, in Succession of McCord, the Fifth Circuit held that the sons’ legally binding assumption of the potential Sec. 2035(b) tax was not too speculative and that the taxpayers were entitled to reduce the gift’s value for the assumption. Although the Fifth Circuit overruled the Tax Court on the issue, the Tax Court’s decision in the case remained good precedent in cases appealable to circuits outside the Fifth.
Tax Court’s Decision
The Tax Court repudiated its earlier holding in McCord and held that a donor could take the value of a donee’s assumption of a Sec. 2035(b) tax liability into account in determining the value of a gift. The Tax Court found that the value of the assumption was not too speculative and that it was not itself a gift. Therefore, the court denied the IRS’s request for summary judgment. In its opinion, the court revisited the issues it had discussed in its opinion in McCord.
Was the value of the assumption too speculative?: In McCord, to support its finding that the assumption of the Sec. 2035(b) liability was too speculative to be valued, the Tax Court pointed to Robinette v. Helvering, 318 U.S. 184 (1943), and its companion case, Smith v. Shaughnessy, 318 U.S. 176 (1943). In Robinette, the Supreme Court held, in a situation involving a complex contingent reversionary interest, that the taxpayers could not reduce a gift’s value by the value of the interest because there was no accepted way of actuarially determining the interest’s value and thus the value was too speculative. In Smith, which involved a simple reversionary interest, the Court held that the taxpayer could reduce the gift’s value by the reversionary interest because it involved only one factor and was capable of being ascertained by recognized actuarial methods.
The Tax Court in McCord found that, like the contingent reversionary interest in Robinette, the value of the assumption of a Sec. 2035(b) tax liability was not capable of being definitively determined. On reconsideration, however, the Tax Court found that a Sec. 2035(b) tax liability assumption was like the simple reversionary interest in Smith and, therefore, in Steinberg’s case the actuarially determined value of the Sec. 2035(b) tax liability assumption could be used to reduce the gift’s value.
To further bolster its position regarding the valuation of the Sec. 2035(b) tax liability assumption, in McCord the Tax Court relied on the cases Murray, 687 F.2d 386 (Ct. Cl. 1982), and Estate of Armstrong, 277 F.3d 490 (4th Cir. 2002), for the proposition that, in advance of a person’s death, no recognized method exists for approximating the burden of the estate tax with a sufficient degree of certitude to be effective for federal gift tax purposes. While in McCord the Tax Court found that the facts in Murray and Estate of Armstrong were only “somewhat different” from the facts before it, in Steinberg’s case the court found the facts of those cases to be different enough that reliance on the opinions from either case was “inapposite with respect to the case at hand.”
The Tax Court also implied in McCord that because estate tax rates and exemption amounts are subject to change (and revocation altogether), it would be difficult to determine the amount of the potential Sec. 2035(b) tax liability. On reconsideration, the court rejected this as a reason for finding the tax amount was too speculative, because in cases where a gift or bequest of property could be reduced by the capital gains tax inherent in the property, courts had uniformly held that a discounted value for the tax based on the capital gains rate could be used. Since capital gains tax rates are as likely to change as estate tax rates, the Tax Court, as the Fifth Circuit had in Succession of McCord, found that there was no reason to treat an estate tax or gift tax differently than a capital gains tax for these purposes.
Finally, with regard to the estate depletion theory, the Tax Court concluded that its distinction in McCord between a benefit to the donor’s estate and a benefit to the donor was incorrect. According to the court, for purposes of the estate depletion theory, the donor and the donor’s estate are inextricably bound, and whether a donor receives consideration is measured by the extent to which the donor’s estate is replenished by the consideration. The court found that in Steinberg’s case and that of the taxpayer in McCord, the estate was replenished (rejecting the IRS’s argument that a replenishment did not occur where the net gift was a “family type transaction”), and thus the donor received a benefit.
Having abandoned all the arguments in favor of the position that the value of an assumption of a Sec. 2035(b) tax liability was too speculative to be determined, the Tax Court determined that such an assumption could be consideration in money or money’s worth for purposes of determining the value of a gift.
Assumption outside the ordinary course of business: In the alternative, the IRS contended that Steinberg’s daughters’ assumption of the potential Sec. 2035(b) estate tax liability was itself a gift because the net gift agreement was between family members, and the net gift agreement was not in the ordinary course of business. Consequently, the value of the assumption of the tax liability would not reduce the value of Steinberg’s gift to her daughters. However, the Tax Court found that the assumption of the tax liability would not necessarily be a gift if it were not in the ordinary course of business; if it was not but was made in consideration in money or money’s worth, it would still not be a gift. The Tax Court found that nothing in the record showed that the net gift agreement was not bona fide and made at arm’s length, so it could be considered to be consideration in money or money’s worth.
Although the Tax Court was not required to follow the Fifth Circuit’s holding in Succession of McCord, it essentially adopted the Fifth Circuit’s analysis and conclusions from that case. Because of the relatively short time period during which additional tax under Sec. 2035(b) could arise, it seems reasonable to accept the reduction of a gift by an actuarially determined value for the assumption of the potential Sec. 2035(b) tax liability.
Steinberg, 141 T.C. No. 8 (2013)