This is the first in a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and trust income tax between June 2015 and May 2016. Part 1 discusses legislative and gift and estate tax developments, and Part 2 will discuss GST tax and trust tax developments as well as President Barack Obama's budget proposals and inflation adjustments for 2016.
Surface Transportation and Veterans Health Care Choice Improvement Act of 2015
On July 31, 2015, the president signed the Surface Transportation and Veterans Health Care Choice Improvement Act of 20151 (the Transportation Act) into law. It contains certain estate and trust provisions.
Basis consistency: In general, Sec. 1014 provides that the basis of property received from a decedent is equal to its fair market value (FMV) as of the decedent's date of death. Despite this clear language, taxpayers have used Rev. Rul. 54-97 to argue that their basis upon the sale of inherited property is something other than FMV and have had some limited success in the courts. The revenue ruling holds that when determining a property's basis, the value of the property as determined for estate tax purposes is deemed to be its FMV at the time of inheritance, but it also permits a taxpayer to rebut this value by clear and convincing evidence unless the taxpayer is estopped by his or her previous actions or statements.
Congress enacted Secs. 1014(f) and 6035 to silence this argument by requiring the basis reflected on an estate tax return to be the same as the basis a person who inherits property from the estate uses to determine gain when it is sold.
Sec. 1014(f) provides that the basis of certain property acquired from a decedent, as determined under Sec. 1014, may not exceed the value of the property as finally determined for estate tax purposes, or if not finally determined, the value of that property as reported on a statement made under Sec. 6035. However, this section only applies to property whose inclusion in the decedent's estate increased the estate's estate tax liability.
Sec. 6035 imposes new reporting requirements for the value of property included in a decedent's gross estate for estate tax purposes. Sec. 6035(a) provides that the executor of any estate required to file an estate tax return must furnish the IRS and the person inheriting any interest in property included in the decedent's gross estate, a statement identifying the value of each interest in that property as reported on the return and any other information the IRS prescribes. The statement is required to be furnished at such time as prescribed by the IRS, but in no case at a time later than the earlier of (1) 30 days after the estate tax return was required to be filed (including extensions, if any); or (2) 30 days after the date the estate tax return is filed. Sec. 6035(b) authorizes the IRS to prescribe regulations, including regulations on property for which no estate tax return is required to be filed and for situations in which the surviving joint tenant or other recipient may have better information than the executor regarding the property's basis or FMV.
To enforce these provisions, the law enacted penalties. The Sec. 6724(d)(1) list of information returns subject to penalty for failure to file has been expanded to include the new Sec. 6035 income tax basis information returns. Sec. 6662 (accuracy-related penalty on underpayments) now imposes understatement penalties on "any inconsistent estate basis," which is defined in Sec. 6662(k) as existing "if the basis of property claimed on a return exceeds the basis as determined under [Sec.] 1014(f)."
These provisions apply to estate tax returns filed after July 31, 2015, the date of enactment. Thus, regardless of the decedent's date of death, an estate tax return filed after July 31, 2015, is required to follow these new rules. The proposed regulations for these provisions are discussed in the "Estate Tax" section in this article.
The basis consistency provisions have long been on the list of revenue raisers in the president's annual budget. They bring into harmony the conflicting objectives of executors of estates and their beneficiaries. Executors seek to minimize estate taxes by valuing property as low as allowable under the estate tax valuation rules, which lowers the basis for beneficiaries when they sell the asset. These consistency provisions should enhance communication between estates and beneficiaries. A beneficiary who knows he or she will soon be selling inherited property will have an interest in ensuring that the executor reports the FMV as accurately as possible on the estate tax return.
Extended filing due dates: The Transportation Act also directs Treasury and the IRS to extend the maximum filing due dates for a variety of returns—including the following trust returns:
- Form 1041, U.S. Income Tax Return for Estates and Trusts: 5½-month extension ending on Sept. 30 for calendar-year trusts. The current extension date is five months ending on Sept. 15.
- Form 5227, Split-Interest Trust Information Return: Six-month extension beginning on the original due date. The current extension is three months.
- Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner: The 15th day of the third month after the close of the trust's tax year and a maximum six-month extension beginning on the original due date, which is already in the regulations.
- Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts: April 15 with a maximum extension for a six-month period ending on Oct. 15 (for calendar filers). Previously, the only way to extend Form 3520 was with the taxpayer's income tax return.
These changes apply to returns for tax years beginning after Dec. 31, 2015.
Protecting Americans From Tax Hikes Act
The Protecting Americans From Tax Hikes (PATH) Act of 2015,2 enacted on Dec. 18, 2015, retroactively extends to the beginning of 2015 a number of expired provisions and makes these extensions permanent; it also retroactively extended other provisions for 2015 and 2016. The PATH Act also included a couple of relevant amendments.
Charitable remainder trusts: The PATH Act amended Sec. 664(e) to provide a valuation rule for the early termination of a net income only charitable remainder unitrust (NICRUT) and a net income charitable remainder unitrust with a makeup provision (NIMCRUT). The valuation rule helps determine the amount of the grantor's income tax charitable contribution deduction for the tax year of trust termination by valuing the remainder interest passing to charity as equal to 5% of the net FMV of the trust assets (or a greater amount, if stated under the terms of the trust instrument) to be distributed each year, disregarding any net income limit.
In several private letter rulings,3 the IRS had stated that the net income limit of NICRUTs and NIMCRUTs was required to be taken into account when valuing the remainder interest and then provided that a reasonable method of valuation would be to use the Sec. 7520 tables but disregarding Sec. 664(e), which provides an assumption that the trust's stated payout percentage is to be paid out each year. Instead, the IRS stated that the taxpayer should assume the payout percentage should be a fixed percentage that is equal to the lesser of the trust's stated payout percentage or the Sec. 7520 rate for the month of termination. The amendment to Sec. 664(e) makes it clear that the rule applies regardless of when the remainder interest is valued, not just at trust creation.
Gifts to Sec. 501(c)(4) organizations: The PATH Act also amended Sec. 2501(a), adding a new Sec. 2501(a)(6), which exempts from gift tax transfers to Sec. 501(c)(4) social welfare organizations, Sec. 501(c)(5) labor, agricultural, or horticultural organizations, and Sec. 501(c)(6) business leagues if the organizations are exempt from income tax under Sec. 501(a) and the transfer is "for the use of" the organizations.
A few years ago, the IRS was examining whether Sec. 501(c)(4) organizations were exempt from gift tax because these organizations had become a popular way to fund political campaigns and were therefore receiving enormous contributions. In September 2013, the IRS stated that it was looking at the issue but would not consider contributions to Sec. 501(c)(4) organizations subject to gift tax until it had made a final determination.4 The IRS also invited Congress to settle the matter—which it has with the enactment of Sec. 2501(a)(6).Gift Tax
Gifts/Bequests From Covered Expatriates
On Sept. 9, 2015, the IRS issued proposed regulations5 on the tax on gifts or bequests from certain individuals who relinquished their U.S. citizenship or ceased to be lawful permanent residents of the United States (referred to as "expatriates") on or after June 17, 2008.
The Heroes Earnings Assistance and Relief Tax Act of 20086 added Sec. 2801, imposing a tax on covered gifts and covered bequests received by a U.S. citizen or resident from a covered expatriate. It applies regardless of whether the covered expatriate acquired the transferred property before or after expatriation.
Sec. 2801 defines "covered expatriate" by reference to Sec. 877A(g)(1): an individual who expatriates on or after June 17, 2008, if on the expatriation date: (1) the individual's average annual net income tax liability is greater than $124,000 (indexed for inflation, $160,000 for 2015) for the previous five tax years; (2) the individual's net worth is at least $2 million (not indexed for inflation); or (3) the individual fails to certify under penalty of perjury that he or she has complied with all U.S. tax obligations for the five preceding tax years.
A U.S. citizen or resident who receives a covered gift or bequest must pay the tax. A domestic trust or a foreign trust (electing to be treated as a domestic trust, "electing foreign trust") that receives a covered gift or bequest is treated as a U.S. citizen and, therefore, is liable for the tax. The U.S. citizen or resident beneficiaries of a nonelecting foreign trust will be taxed when distributions are made from the trust.
In October 2009, the IRS issued Notice 2009-85, which provided guidance under Sec. 877A and deferred the Sec. 2801 reporting and tax obligations until final regulations are issued.
Definitions: Sec. 2801 imposes a tax on an individual who is a citizen or resident of the United States. Residency refers to residency under Chapters 11 (estate tax) and 12 (gift tax). Whether an individual is a U.S. resident for estate or gift tax purposes is based on whether the individual is domiciled in the United States, which means living in the United States, for even a brief time, with no intention of later moving (note that Sec. 877A adopts the income tax definition of "resident"). For U.S. income tax purposes, residency depends on whether a person elects to be a permanent resident of the United States (i.e., a green-card holder) or the number of days a person is present in the United States.
The proposed regulations define "covered gift" by reference to the definition for gift tax purposes. Also, the proposed regulations define "covered bequest" as any property acquired directly or indirectly because of the death of a covered expatriate.
If an expatriate meets the definition of a covered expatriate, the expatriate is treated as a covered expatriate for purposes of Sec. 2801 at all times after the expatriation date, except for periods during which the individual is subject to U.S. estate or gift tax as a U.S. citizen or resident.
What's excluded: The following items are not covered gifts or bequests:
- Taxable gifts reported on a covered expatriate's timely filed U.S. gift tax return, provided the gift tax is timely paid;
- Property included in the covered expatriate's gross estate and reported on the expatriate's timely filed U.S. estate tax return, provided the estate tax is timely paid;
- Qualified disclaimers (as defined in Sec. 2518) of property made by a covered expatriate;
- Charitable donations that qualify for the gift or estate tax charitable deduction;
- The charitable remainder interest of a charitable remainder trust;
- A gift or bequest to a covered expatriate's U.S. citizen spouse if the gift or bequest, if given by a U.S. citizen, would qualify for the gift or estate tax marital deduction;
- A gift or bequest of a partial or terminable interest in property that a covered expatriate makes to his or her spouse only to the extent that the gift or bequest is qualified terminable interest property (QTIP) (as defined in Secs. 2523(f) and 2056(b)(7)) and a valid QTIP election is made; and
- A bequest from a covered expatriate to his or her non-U.S. citizen surviving spouse who is a U.S. resident to the extent the bequest is made to a qualified domestic trust (QDOT) (as defined in Sec. 2056A) and a valid QDOT election is made.
The proposed regulations do not adopt the gift tax rule of treating the trust beneficiary or holder of an immediate right to withdraw the property as the recipient of the property for determining the recipient of the covered gifts and bequests made in trust. Instead, if a covered expatriate makes a transfer in trust and the transfer is a covered gift or bequest, the transfer is treated as a covered gift or bequest to the trust, regardless of the beneficial interests in the trust or whether any person has a general power of appointment or a withdrawal power over the trust property.
The proposed regulations confirm that the exercise, release, or lapse (to the extent provided in Secs. 2041(b)(2) and 2514(e)) of a covered expatriate's general power of appointment for the benefit of a U.S. citizen or resident is a covered gift or bequest. Also, a covered expatriate's grant of a general power of appointment over property not held in trust is a covered gift or bequest to the holder of the power as soon as the power is exercisable, and the transfer of the property subject to the power is irrevocable.
Liability for Sec. 2801 tax: Under the proposed regulations, the U.S. citizen or resident who receives the covered gift or bequest is liable for the Sec. 2801 tax. A domestic trust or electing foreign trust that receives a covered gift or bequest is also liable; however, the payment of the Sec. 2801 tax for which the trust is liable would not result in a taxable distribution under Sec. 2621 to any beneficiary of the trust for GST tax purposes.
The proposed regulations include a special rule for certain nonelecting foreign trusts that become domestic trusts (migrated foreign trusts). A migrated foreign trust is treated as a domestic trust for the entire year during which the change from foreign trust to domestic trust occurred. The trust must file a timely Form 708, United States Return of Gifts or Bequests From Covered Expatriates, for that year and pay the Sec. 2801 tax on all covered gifts and covered bequests received during that year. The trust must also pay the Sec. 2801 tax on the portion of the trust's value attributable to any covered gifts and covered bequests received before the year in which it becomes a domestic trust determined as of Dec. 31 of the year before the year it becomes a domestic trust.
Calculation of tax: The proposed regulations require the Sec. 2801 tax to be calculated by reducing the total amount of covered gifts and bequests received during the calendar year by the dollar amount of the Sec. 2503(b) exclusion for gifts to donees for that calendar year ($14,000 for 2016) and multiplying the net amount by the highest estate or gift tax rate in effect during the calendar year (currently 40%). The resulting tax is then reduced by any estate or gift tax paid to a foreign country on the covered gifts or bequests.
Payment of tax: The Sec. 2801 tax must be reported and paid on Form 708 filed each calendar year in which a covered gift or bequest is received, except when the gift or bequest is less than the Sec. 2503(b) exclusion. The proposed regulations also explain the information taxpayers must submit with Form 708.
The proposed regulations require Form 708 be filed on or before the 15th day of the 18th calendar month following the close of the calendar year in which the covered gift or covered bequest was received. The due date for a Form 708 reporting a covered bequest that is not received on the decedent's date of death is the later of (1) the 15th day of the 18th calendar month following the close of the calendar year in which the covered expatriate died; or (2) the 15th day of the sixth month of the calendar year following the close of the calendar year in which the covered bequest was received.
Foreign trusts: If a covered gift or bequest is made to a foreign trust, the proposed regulations apply the Sec. 2801 tax to any distributions from that trust, whether income or principal, to a beneficiary that is a U.S. citizen or resident (unless the trust elects to be treated as a domestic trust). The proposed regulations explain that the Sec. 2801 tax applies only to the portion of a distribution from a foreign trust that is attributable to covered gifts or bequests contributed to the foreign trust. The proposed regulations further explain how to compute the amount of a distribution from a foreign trust that is subject to the Sec. 2801 tax.
Sec. 2801 allows a foreign trust to be treated as a domestic trust solely for purposes of Sec. 2801. For a foreign trust to elect to be treated as a domestic trust, the proposed regulations require the trustee of the foreign trust to make the election on a timely filed Form 708 and timely pay the Sec. 2801 tax due, if any, by the Form 708 due date for that year. The trustee also is required to include a computation of how the applicable ratio and tax liability were calculated.
Additionally, the proposed regulations require the trustee to designate and authorize a U.S. agent and to agree to file annually a Form 708 to certify that the foreign trust received no covered gifts or bequests or to report and pay the tax, if any, on covered gifts and bequests received by the foreign trust during the calendar year. The trustee also has to report the portion of the trust attributable to covered gifts and bequests and all distributions attributable to covered gifts and bequests made to U.S. recipients in years before the election. In addition, the trustee is required to notify the permissible U.S. distributees of the trust that the trustee is electing for the foreign trust to be treated as a domestic trust.
For calendar years before the election, the proposed regulations require the foreign trust to pay the Sec. 2801 tax liability for all prior calendar years when the election is made on Form 708. The election will be terminated if the electing foreign trust fails to file the Form 708 on an annual basis or pay the Sec. 2801 tax.
Other provisions: The proposed regulations also contain rules for:
- Valuing covered gifts and bequests;
- Determining when a covered gift or bequest is received; and
- Determining whether the tax under Sec. 2801 is due.
The IRS will issue Form 708 after it finalizes the proposed regulations.
Implications: For those covered expatriates who made gifts or bequests on or after June 17, 2008, the proposed regulations provide insight. Beneficiaries of a gift or bequest from a covered expatriate should have a plan for eventual tax payment. Keep in mind, however, that until the IRS issues the final regulations, the Sec. 2801 tax continues to be deferred. The preamble to the proposed regulations states that taxpayers will be given a "reasonable period of time" after the final regulations are issued to file Form 708 and pay any tax due and that interest will not accrue on those payments until that date has passed.
Going forward, when U.S. citizens and residents receive a gift or bequest, they will need to evaluate whether the gift or bequest is from a covered expatriate. Most of the time it is easy to determine, but sometimes the U.S. citizen or resident donee may not know whether the foreign donor was a covered expatriate. The proposed regulations provide for a protective Form 708 filing that may be appropriate to alert the IRS that the individual is taking the position that he or she received a gift or bequest from a foreign person who is not a covered expatriate and no Sec. 2801 tax is due, which will start the statute of limitation.
In Steinberg,7 the Tax Court ruled that the donees' agreement to assume any potential estate tax liability under Sec. 2035(b) should be considered in determining the FMV of a gift, resulting in a reduction in the gift's FMV.
On April 17, 2007, after lengthy negotiations, the 89-year-old donor entered into a binding agreement to transfer $109 million in assets to her four children. The children assumed liability for any federal gift tax imposed as a result of the donor's gift (commonly referred to as a "net gift" arrangement, which reduces the value of the gift by the gift tax liability assumed). The children also agreed to assume liability for any estate tax that may arise under Sec. 2035(b) should the donor pass away within three years of the date of the gift (commonly referred to as a "net, net gift" arrangement). Under Sec. 2035(b), the gross estate includes any gift tax paid by the decedent within three years of death.
The donor filed a timely gift tax return that valued the net gift at approximately $72 million using the Sec. 7520 tables to value the children's assumption of any potential Sec. 2035(b) estate tax liability at approximately $5.8 million. The children established an escrow fund with $40 million of the original gift amount. They used $32 million to satisfy the gift tax liability and held the remainder to satisfy any estate tax in the event that the donor died within three years. The IRS disagreed with the donor's discount for the potential Sec. 2035(b) tax and issued the donor a notice of deficiency for $1.8 million in gift tax.
First, the IRS argued that since the donor's estate would ultimately be subject to state and federal estate tax, the children as current beneficiaries of her estate should not have the benefit of reducing the value of the gifts by a tax that might not occur (i.e., if the donor lives three years post gift). The Tax Court rejected the IRS's argument and explained that the agreement was arm's-length because at the time, the children had no guarantee of remaining beneficiaries of the donor's estate—as she was alive and could change her estate plan. If she did, the children could have become liable for a Sec. 2035(b) tax they might never have been burdened with by way of a reduction in their inheritances.
Second, the IRS unsuccessfully argued that use of the Sec. 7520 mortality tables for valuation purposes was inappropriate, as they ignored the donor's health—asserting the tables are to be used only for valuing annuities, life interests, terms of years, remainders, and reversionary interests. The court explained that the mortality tables are used to determine life expectancy of an individual who is not terminally ill. The mortality tables necessarily take some account of a person's health and general medical prognosis when arriving at a probability of death. Since the IRS did not provide evidence to suggest that the mortality tables produce an unreasonable result, their use was proper.
Finally, the Tax Court clarified that the fact that a payment is contingent does not preclude use of the mortality tables.
In a pair of related cases, the Tax Court determined that the transfer of stock to a trust for one brother was not a gift because he received full and adequate consideration while in the other brother's case, there was a gift because the court found there was no consideration.
In Estate of Edward Redstone,8 the Tax Court concluded that a taxpayer's 1972 transfer of stock to a trust for the benefit of his children was not a taxable gift because the transfer was made for full and adequate consideration in money or money's worth. It was irrelevant that the beneficiaries of the trust were not the source of the consideration.
The taxpayer's father entered the drive-in movie theater business in 1936 and bought real estate throughout the northeastern United States. The taxpayer and his brother owned a portion of the business, which was organized in multiple entities, and participated in running the business. In 1959, the business was reorganized as National Amusements Inc. (NAI), a company used to hold the multiple properties, manage the properties, and manage the drive-in movie theaters.
Upon NAI's 1959 incorporation, the taxpayer, his father, and his brother each contributed their stock in the preexisting companies. The taxpayer's father also contributed additional cash such that his contributions of cash and stock accounted for 47.88% of the total capital contribution. The taxpayer's and his brother's contributions accounted for 25.63% and 26.49% of the capital contributions, respectively. NAI issued a total of 300 class A voting common shares, which the father decided to divide equally—100 shares each to the taxpayer, his father, and his brother.
In the early 1970s, a rift in the family resulted in the taxpayer's being forced out of the family business, whereupon, the taxpayer demanded all of his NAI stock. His father refused to deliver the stock, claiming that, as a result of the disproportionate capital contributions in 1959, a portion of the taxpayer's stock had been held in an "oral trust" for the benefit of the taxpayer's children. In 1972, after lengthy negotiations and two lawsuits, the parties reached a settlement, under which the taxpayer transferred one-third of the 100 disputed shares into a trust for his children's benefit, in consideration of which the taxpayer was acknowledged as the rightful owner of the remaining two-thirds of the disputed shares. NAI redeemed the taxpayer's shares for $5 million.
In 2006, the taxpayer's son filed suit, arguing that additional stock should have been transferred to the trusts in 1972 based on the purported existence of a prior "oral trust." In that litigation the taxpayer testified that he had been forced to renounce his ownership interest in one-third of the shares to obtain payment for the remaining two-thirds, and he believed the "oral trust" was a specious argument his father and brother used to justify their position. The taxpayer also testified that he paid no gift tax in 1972 when he transferred the stock to the trust for his children's benefit because he did not make a gift. The presiding court dismissed the suit.
After the taxpayer died on Dec. 23, 2011, the IRS issued a notice of deficiency to the taxpayer's estate for $737,625 in gift taxes for the calendar quarter ended June 30, 1972. In addition, the IRS assessed additions to tax for fraud and, in the alternative, negligence.
The Tax Court began its analysis by noting that Regs. Sec. 25.2511-1(g)(1) provides that a transfer of property in exchange for adequate and full consideration does not constitute a gift. It then noted that Regs. Sec. 25.2512-8 essentially provides that a transfer of property made in the ordinary course of business will be considered to have been made for adequate and full consideration if the transfer is (1) bona fide; (2) at arm's length; and (3) free of any donative intent. The court concluded that the 1972 transfer of stock by the taxpayer to the trust for the benefit of his children represented a bona fide settlement of a genuine dispute, was made at arm's length, and lacked any donative intent.
Despite the fact that the taxpayer made the transfer in the ordinary course of business, the IRS argued that the 1972 transfer of stock was a taxable gift because the taxpayer's children, the beneficial transferees, did not provide any consideration since they were not parties to the litigation or settlement. The Tax Court explained that the IRS's argument had no basis in the regulations. The IRS focused on whether the transferee provided consideration, while the regulations focus on whether the transferor received consideration. The court noted that the regulations never mention the source of the consideration and found that the trust beneficiaries were not the source of the consideration was irrelevant for analyzing whether a taxpayer made a transfer for full and adequate consideration. Therefore, the court concluded that the taxpayer's estate was not liable for any deficiency in gift tax or additions to tax.
The issue of the "source of consideration" was an issue of first impression for the Tax Court. Although the IRS closely scrutinizes transactions between family members, the taxpayer-favorable analysis in this case gives taxpayers and practitioners more certainty as to the gift tax treatment of settlements of intra-family disputes. Keep in mind that settlements that are not made in the ordinary course of business (e.g., not bona fide or not made at arm's length) may be treated as gifts, notwithstanding the source of consideration, because they would not be treated as transfers made for adequate and full consideration.
In the related case, Sumner Redstone,9 the Tax Court came to the opposite conclusion that the taxpayer made a taxable gift in 1972 when he transferred stock to trusts for his two children's benefit.
Most of the facts in this case were the same as the Edward Redstone case. Sumner Redstone also transferred the one-third of his shares to a trust for the benefit of his children and argued that, like his brother, he made no gift to the trust.
Three weeks after the settlement of Edward's case in 1972, Sumner transferred 33⅓ of his 100 NAI shares to two trusts for the benefit of his two children. The taxpayer created these trusts and funded them with NAI shares as a gesture of goodwill toward his father, who wanted to ensure the financial security of his four grandchildren on equal terms. The taxpayer was not required to make these transfers under the settlement agreement. In the 2006 litigation, the taxpayer testified that he transferred NAI shares to trusts for the benefit of his children voluntarily and to appease his father.
The taxpayer received advice about the tax consequences of his transfer of stock to the trusts for his children's benefit from Samuel Rosen, a tax adviser very familiar with the Redstone family litigation, who provided a letter that concluded that the taxpayer was not required to file a gift tax return because he had made no taxable gift. The taxpayer testified that he had relied on his adviser's conclusions that he did not need to file a gift tax return.
In 1975, an IRS revenue agent investigated whether the taxpayer made taxable contributions to political campaigns and asked the taxpayer to identify and document all transfers he made to political committees from 1970 through 1972. After the taxpayer complied, the revenue agent concluded "there was no necessity to solicit a gift tax return for 1972" from the taxpayer.
In 2011, after the taxpayer's 1972 transfer of NAI stock came to the IRS's attention, it began a gift tax examination. The taxpayer did not complain that the IRS was subjecting him to a second examination of his 1972 gift tax liability. After the IRS issued a notice of deficiency on Jan. 11, 2013, the taxpayer raised the possibility that the 2011 examination constituted a "second examination" in violation of Sec. 7605(b).
The Tax Court began its analysis by noting that the notice of deficiency was timely, even though the IRS issued it 41 years after the transfer because the taxpayer never filed a gift tax return to report the 1972 transfer, and as a result, the statute of limitation had not been tolled. It then noted that it was unclear whether the 2011 examination constituted a second examination under Sec. 7605(b), but the taxpayer had consented to the exam, waiving any right to claim a violation of Sec. 7605(b).
The Tax Court then analyzed whether the taxpayer's transfer of NAI stock to trusts for the benefit of his children constituted gifts. The taxpayer argued that these transfers, like his brother's transfers, did not constitute gifts because he made them in the ordinary course of business and for adequate consideration.
Although the settlement agreement may have prompted the taxpayer's transfer, as it had his brother's, the Tax Court concluded that there was no evidence that the transfer was in the ordinary course of business: (1) There was no claim against the taxpayer; (2) there were no arm's-length negotiations; and (3) he received no consideration. In addition, the taxpayer's testimony in the 2006 litigation firmly supported the conclusion that the taxpayer made his transfer with donative intent and not in the ordinary course of business.
Ultimately, the Tax Court concluded that the taxpayer made a taxable gift of $2.5 million, based on the IRS's expert testimony on the value of the shares. In addition, the court concluded that the taxpayer was not liable for an addition to tax for fraud because there was no evidence that the taxpayer relied on his father's oral trust concept in an effort to evade gift tax liability or for negligence because he relied in good faith on a tax professional's advice.
This case differs from Edward'sbecause Sumner voluntarily transferred his stock to trusts for his children's benefit. In contrast, Edward transferred stock to trusts for his children's benefit in consideration for his father's and Sumner's recognition that he was the outright owner of a portion of his NAI shares and NAI's payment of $5 million to him in exchange for those shares. Both cases occurring so many years after the taxpayers made the gifts are a good reminder that the statute of limitation does not begin to run until a gift tax return is filed.
Sale to Grantor Trust
In two cases docketed in the Tax Court, the estates of Donald and Marion Woelbing reached a settlement with the IRS on Mr. Woelbing's sale of stock to an intentionally defective grantor trust (IDGT).10
In 2006, Mr. Woelbing sold all of his nonvoting stock of Carma Laboratories Inc. to a grantor trust in exchange for an interest-bearing promissory note for $59,004,508.05, an amount that an independent appraiser determined. The installment sale agreement included a "defined value clause," allowing the number of shares to automatically adjust so that the FMV of the stock purchased equaled $59,004,508.05.
It is the author's understanding and that of many in the estate planning community that the IRS generally will respect sales to an IDGT if the grantor seeds the trust with assets that equal or exceed 10% of the face value of the promissory note. The trust owned three life insurance policies with an aggregate cash surrender value of $12,635,722 (approximately 21% of the purchase price), which could have been pledged as collateral for a loan to make payments on the promissory note. Additionally, at the time of the sale, two trust beneficiaries executed personal guarantees for 10% of the purchase price. Thus, it seemed the trust had significant financial capability to repay the promissory note without using all the Carma stock and that the IRS would respect the transaction.
However, the IRS ignored the note, treating it as a retained interest that under Sec. 2702 had a $0 value, and that the decedent made a gift of $117,000,000 when he purportedly sold the stock to the trust. Additionally, the IRS argued that $162,000,000 should be included in the decedent's estate under Sec. 2036 because the note did not constitute debt. Finally, the IRS argued that because the beneficial enjoyment of the Carma stock was subject to a right to alter, amend, revoke, or terminate by Mr. Woelbing at the time of his death, the value of the stock was includible in his gross estate under Sec. 2038.
The parties settled their dispute, stipulating that the Woelbings did not owe additional gift tax and that Mr. Woelbing's estate did not owe additional estate tax.
It has been reported in Steve Leimberg's May 24, 2016, Estate Planning Newsletter that the parties agreed to an increased value of the Carma stock sold to the trust. In that case the number of shares sold to the trust would have been reduced under the defined value clause, and more shares would have been included in Mr. Woelbing's estate. Since the increased shares in Mr. Woelbing's estate did not result in additional estate tax, it must be assumed that the shares increased the estate tax marital deduction and will be included in Mrs. Woelbing's estate when she dies.
The arguments the IRS raised here are basically the same arguments it raised in a similar case that was docketed for trial by the Tax Court that was also settled.11
Although this settlement is not precedent, there are a few key takeaways. Seeding an IDGT with certain types of assets (e.g., cash or marketable securities) may be less likely to draw the IRS's attention than others (e.g., split-dollar life insurance policies or beneficiary guarantees). If what has been informally reported is true, it is interesting that the IRS respected the defined value clause, which returned shares to the estate. The IRS has been aggressively attacking the use of these clauses, but it has failed to find favor with the courts. Most recently, it attacked a similar clause in Wandry,12 and the Tax Court sided with the taxpayer.Estate Tax
Consistency in Basis Reporting
On March 4, 2016, proposed regulations13 were issued on (1) the requirement for a recipient's basis in certain property acquired from a decedent to be consistent with the value of the property as finally determined for federal estate tax purposes; and (2) the reporting requirements for executors or other persons required to file federal estate tax returns. Simultaneously, temporary regulations14 were issued providing that executors and others required to file or furnish a statement under Sec. 6035(a)(1) or (a)(2) before March 31, 2016, may do so until March 31, 2016 (this time was later extended to June 30, 201615).
As discussed above in the "Legislation" section, the Transportation Act added (1) Sec. 6035, generally requiring the executor of an estate that files its estate tax return after July 31, 2015, to provide a statement identifying the value of property reported on the return to both the IRS and the beneficiaries acquiring any interest in the property; and (2) Sec. 1014(f), providing that the basis of any property acquired from a decedent to which Sec. 1014(a) applies may not exceed the final estate tax value of the property or, if the final value has not yet been determined, the value reported on a statement furnished under new Sec. 6035.
Sec. 1014(f): Prop. Regs. Sec. 1.1014-10(a)(1) provides that a taxpayer's initial basis in property subject to the consistent basis rules of Sec. 1014(f) may not exceed the property's final value, which is the value as finally determined for estate tax purposes.
Because the consistent basis requirement of Sec. 1014(f)(1) applies only if including the property at issue in the decedent's gross estate increases the estate's estate tax liability, the proposed regulations expressly exclude all property reported on a federal estate tax return if, after application of all available credits (other than a credit for prepayment of tax), no federal estate tax is due. If estate tax was payable, all property included in the gross estate is subject to the consistent basis requirement except (1) property qualifying for the estate tax charitable deduction under Sec. 2055 or marital deduction under Sec. 2056 or Sec. 2056A; and (2) tangible personal property for which an appraisal is not required under Regs. Sec. 20.2031-6(b).
Under the Sec. 1014(f) consistent basis rules, the final value of property has been determined if (1) the value is reported on a federal estate tax return and the IRS does not adjust or contest the amount before the statute of limitation closes; (2) the value is not reported on a federal estate tax return, the IRS determines or specifies the value, and the executor does not contest it before the statute of limitation closes; or (3) the value is determined by a court or under an agreement. Further, the proposed regulations provide that a deficiency and underpayment may result if a taxpayer claims an initial basis in property consistent with the amount reported on the statement furnished to the taxpayer under Sec. 6035(a) and the subsequently determined final value of property differs from that initial basis claimed.
Prop. Regs. Secs. 1.1014-10(a)(2) and 1.6662-8(b) clarify that Secs. 1014(f) and 6662(k) "do not prohibit adjustments to the basis of property as a result of post-death events that are allowed under other" Code sections, according to the preamble to the proposed regulations. Under the proposed regulations, a beneficiary's initial basis in inherited property could not exceed the property's final value for federal estate tax purposes, and adjustments to the basis permitted for post-death events (e.g., depreciation, sale, exchange, or disposition of the property) would not cause the taxpayer's basis in the property on the date of a taxable event to exceed the final value of the property. Examples provided in the proposed regulations illustrate how the final value of a partnership interest with nonrecourse debt will be the value of the partnership interest as finally determined for estate tax purposes, and that any subsequent adjustments to basis to account for the debt are permitted.
The proposed regulations provide guidance for situations in which property subject to Sec. 1014(f) was omitted from the estate tax return or is discovered after the estate tax return was filed. If an estate tax return was already filed, (1) the final value will be determined as discussed previously if the executor files, before the statute of limitation closes, an initial or supplemental estate tax return to report this property; and (2) the final value of the property will be zero if the executor does not report the property on an initial or supplemental estate tax return before the statute of limitation closes. If no federal estate tax return was filed, the final value of all property includible in the gross estate that would have generated or increased the estate's estate tax liability is zero until the final value is determined under the previously discussed rules.
Sec. 6035: Prop. Regs. Sec. 1.6035-1(a)(1) requires an executor who is required to file a federal estate tax return to file an information return with the IRS, and provide a statement to the estate's beneficiaries, detailing certain property included on the estate tax return and its final value.
The proposed regulations define the "information return" required under Sec. 6035 as Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent, which includes a Schedule A for each person who has received or will receive certain property from the estate or as a result of the decedent's death.
The proposed regulations provide that the Sec. 6035 filing requirements do not apply to estates filing estate tax returns solely to make the Sec. 2010(c)(5) portability election or a GST tax election or exemption allocation.
Prop. Regs. Sec. 1.6035-1(b) explains that all property reported or required to be reported on the federal estate tax return must be reported on Form 8971, with four exceptions: (1) cash; (2) income in respect of a decedent; (3) items of tangible personal property for which an appraisal is not required under Regs. Sec. 20.2031-6(b); and (4) property sold or otherwise disposed of by the estate in a transaction in which capital gain or loss is recognized. The proposed regulations state that property for which basis is determined in whole or in part by reference to property reported or required to be reported on the estate tax return, such as property acquired in a like-kind exchange or involuntary conversion, for these purposes is treated as property reported or required to be reported on an estate tax return. For a decedent who was not a U.S. citizen or resident, only property subject to U.S. estate tax would have to be reported.
If, by the due date of Form 8971, the executor has not determined how the estate's property will be distributed, Prop. Regs. Sec. 1.6035-1(c)(3) requires the executor to report on each beneficiary's Schedule A all of the property that could be used to satisfy the beneficiary's interest. The preamble notes that "this results in the duplicate reporting of those assets on multiple [Schedules A], but each beneficiary will have been advised of the final value of each property that may be received by that beneficiary and therefore will be able to comply with the basis consistency requirement, if applicable." If a beneficiary is a trust, estate, or business, the executor furnishes the beneficiary's statement to the trustee, executor, or business entity itself, rather than to the beneficiaries of the trust or estate or owners of the business. If the executor is unable to locate a beneficiary by the time the information return is due, the executor must explain the efforts taken to find the beneficiary. If the beneficiary is ultimately found, the executor must provide the beneficiary with a statement and file a supplemental information return with the IRS within 30 days.
The proposed regulations require the executor to file Form 8971 (including all Schedules A) with the IRS and provide Schedule A to beneficiaries within the earlier of 30 days after the due date for the federal estate tax return, including extensions, or the date that is 30 days after the date on which that return is filed with the IRS. The proposed regulations provide a transition rule applicable to any federal estate tax return due on or before July 31, 2015, but filed after July 31, 2015. For these returns, the due date for Form 8971 and Schedule A is 30 days after the date the estate tax return is filed. The due date for a supplemental information return or statement is 30 days after (1) the final value of the property is determined; (2) the executor discovers that incorrect information was reported on the information return or statement; or (3) a supplemental federal estate tax return is filed. For probate property or property held in the decedent's revocable trust, if these events occur before the property has been distributed to the beneficiary, a supplemental information return or statement is not due until 30 days after the property is distributed to the beneficiary.
Beneficiaries or subsequent transferees who later transfer property that was reported to them on Schedule A are required to file a supplemental Form 8971 and provide Schedule A to the transferee if the transferee is related to the transferor (as defined under Sec. 2704(c)(2)) or is a grantor trust of which the transferor is the owner and will determine its basis by reference to the beneficiary's basis in the property.
Overall, the regulations are helpful in determining whether Sec. 1014(f) or Sec. 6035 applies, to whom these provisions apply, to what assets they apply, what information needs to be reported, and when it needs to be reported. However, there are a couple of surprises. First, the new requirement to report subsequent transfers is somewhat unexpected as it would require persons other than "executors" to comply with Sec. 6035 if they transfer inherited assets to another in a transaction in which gain or loss was not recognized, even though the statute does not impose a filing requirement on them. The preamble says the reason for this requirement is Treasury's and the IRS's concern that "opportunities may exist in some circumstances for the recipient of such reporting to circumvent the purpose of the statute (for example, by making a gift of the property to a complex trust for the benefit of the transferor's family)." It is also important to note that there is no time limit on the subsequent transfer rule.
A second surprise is the provision assigning a zero basis to property for which basis should have been reported on an estate tax return, but was not. Specifically, property of a decedent discovered after the estate tax return has become final (i.e., after the statute of limitation has run) has a basis of zero. This provision would seem to conflict with Sec. 1014(a), which has no such requirement. The general rule in Sec. 1014(a)(1), providing that the FMV of property is the value of the property on the decedent's death, has more or less been the rule since the 1930 Supreme Court decision in Brewster v. Gage.16 If Congress had intended to modify an 85-year-old Supreme Court decision by tying basis to the listing of property on a return, it would seem logical that it would have either amended Sec. 1014(a) when adding Sec. 1014(f) or specifically addressed that outcome in the legislative history.
Estate Tax Closing Letters
The IRS practice of issuing closing letters to estates for estate tax purposes acknowledging that it has accepted the estate tax return as filed or as adjusted under audit used to be automatic. Under this process, for most estates, the IRS will not make any further adjustments to the estate tax return after it issues the closing letter, unless there was a material misstatement or fraud.
On June 16, 2015, the IRS updated its "Frequently Asked Questions on Estate Taxes," to provide that, for estate tax returns filed on or after June 1, 2015, closing letters will be issued only if the taxpayer requests it and that these requests should not be submitted until four months after the return is filed.
Some commentators have suggested that the IRS changed its closing letter practice because of the large number of estate tax returns it thinks it will receive to elect to preserve the deceased spouse's unused exemption amount. In general, all executors of estates worth more than the estate tax exemption amount will want to obtain an estate tax closing letter before they distribute all the estate's property to protect themselves from possible liability for estate taxes.
To request a closing letter, the estate's representative must call an IRS number and state the decedent's name, Social Security number, and date of death. The IRS will issue the closing letter to the executor's address on record.
After tax practitioners voiced their concern about no longer receiving closing letters automatically, in December 2015 the IRS issued additional guidance on its website that the IRS views an estate's IRS account transaction, "which reflect[s] transactions including the acceptance of Form 706 and the completion of an examination, may be an acceptable substitute for the estate tax closing letter." A registered tax professional may use the IRS's Transcript Delivery System, or an authorized representative may make the transcript request using Form 4506-T, Request for Transcript of Tax Return. Since decisions to audit a Form 706 are made four to six months after filing the return, the IRS requests advisers wait four to six months before requesting an account transcript. When analyzing the transcript, a transaction code 421 indicates a Form 706 has been accepted as filed or that the examination is complete. The appearance of code 421 will display "Closed examination of tax return" in all instances. Consequently, if code 421 does not appear, the return remains under review.
Thus, tax practitioners now have two options to receive communication that an estate is closed: (1) call to request a closing letter or (2) review the account transcript for code 421.
Estate Tax Inclusion
Purdue: In Estate of Purdue,17 the Tax Court ruled that the assets transferred to a limited liability company (LLC) were not includible in the decedent's estate for estate tax purposes because the decedent created the LLC for legitimate nontax reasons. It further ruled that gifts of LLC interests made during the decedent's life were gifts of a present interest. Finally, it ruled that the interest on loans from the LLC to the estate was deductible for estate tax purposes.
The decedent died in 2007, having survived her husband, who died in 2001. Her husband was a founding partner of a law firm and a principal investor in a cable company later purchased by a larger company. The decedent, who had five children and many grandchildren, had, together with her husband, amassed more than $28 million by the late 1990s, from marketable securities held in five separate accounts at three separate management firms—operating independently with no coordination between the management companies. They also owned a one-sixth interest in a large commercial building in Hawaii valued at approximately $500,000.
The decedent and her husband engaged an estate planning attorney to develop a gift and estate plan, which, once executed in 2000, ultimately included various lifetime gifts using available gift and GST tax lifetime exemptions and annual exclusions, an LLC funded with the marketable securities and the building, and various trusts (an irrevocable trust funded with $400,000, and family residence trusts for the family home). The decedent retained LLC interests she received in exchange for those transfers.
The estate planning attorney recommended the centralization of management of family assets, maintenance of ownership interests, asset protection, flexibility, and family education and coordination, all of which goals were conveyed to family members, who met for regular meetings, kept minutes, and made LLC filings. Interests in the LLC could not be sold, and LLC dividends could not be declared without the unanimous approval of all members.
From 2002 to 2007, the decedent made annual gifts of LLC interests to the irrevocable trust subject to withdrawal powers. Each year valuation summaries were prepared along with suggested investment strategies.
The decedent's husband's estate created additional testamentary trusts upon his death, including a QTIP trust. Upon the decedent's death, the attorney contacted the family about options to pay her estate tax liability, either by a dividend or a loan, both from the LLC. One of the decedent's daughters, who previously borrowed substantial sums from her parents, refused to support either option because she wanted a larger distribution for personal use, which her siblings did not support. The deadlock resulted in the need for family members to loan money to the decedent's estate. The executors timely filed the estate tax return, and the estate later received a gift tax deficiency and estate tax deficiency notice from the IRS.
The three issues before the Tax Court were whether the assets the decedent contributed to the LLC were includible in the decedent's estate, whether the gifts of the LLC interests during the decedent's life were gifts of a present interest, and whether the interest on the loan from the family members to the estate was deductible on the decedent's estate tax return.
Sec. 2036(a) includes in a decedent's gross estate the value of any interest in property transferred by the decedent in which the decedent retained or reserved (1) for his or her life, (2) for any period not ascertainable without reference to his or her death, or (3) for any period which does not, in fact, end before his or her death: (a) the use, possession, or right to the income or other enjoyment of the transferred property; or (b) the right to designate the person who shall possess or enjoy the transferred property or its income. Sec. 2036(a) contains an exception for a transfer if it was a bona fide sale for adequate and full consideration (the "bona fide sale exception").
In addressing whether the bona fide sale exception had been satisfied, the Tax Court used the test set forth in Bongard, 124 T.C. 95 (2005): (1) that there is a legitimate and significant nontax reason for creating the family limited partnership (FLP) ("bona fide sale" criterion); and (2) that the transferors receive interests in the FLP proportionate to the value of their transferred property ("full and adequate consideration" criterion).
The decedent's estate argued that the decedent had seven nontax motives for transferring the property: (1) to relieve decedent and her husband from the burdens of managing their investments; (2) to consolidate their investments with a single adviser to follow a written investment plan; (3) to educate the decedent's five children to jointly manage a family investment company; (4) to avoid repetitive asset transfers among multiple generations; (5) to create a common ownership of assets for efficient management and meeting minimum investment requirements; (6) to provide voting and dispute resolution rules and transfer restrictions to facilitate joint ownership and management by a large number of family members; and (7) to provide the decedent's children with a minimum annual cash flow. The IRS argued that the LLC was a testamentary substitute and that transfer tax savings were the primary motivation for forming it.
The Tax Court looked first to whether the transfers to the LLC met the bona fide sale criterion of Bongard. Trial testimony, coupled with the estate tax attorney's memorandum and the LLC agreement, suggested that a significant purpose of establishing the LLC was to consolidate investments into a family asset managed by a single adviser and that this plan was followed by the family. In addition to this significant nontax purpose, the court also cited the following factors: (1) The decedent and her husband had retained substantial assets and thus were not financially dependent on LLC distributions; (2) there was little commingling of the decedent's funds with the LLC's funds; (3) the LLC's formalities were respected by maintaining its own bank accounts and holding meetings at least annually; (4) the decedent and her husband transferred all title in the property to the LLC and were in good health at the time. Thus, the bona fide sale criterion had been satisfied.
The Tax Court then looked to whether the full and adequate consideration criterion of the Bongard test had been satisfied, which demands more than merely a change in the form in which property is held—"circuitous 'recycling' of value" and "unilateral paper transformations" are not sufficient. Because the court had already determined that the decedent had a legitimate, nontax purpose for transferring property to the LLC, it found that the transfers to the LLC were not a mere attempt to change the form in which the decedent held the property and that the full and adequate consideration criterion had been satisfied.
The Tax Court next determined that the transfers to the trust were gifts of a present interest.
The Tax Court then addressed whether the estate could deduct interest it paid on the loan to pay the estate taxes. It noted that an estate can deduct interest on a loan if it is a bona fide loan obligation and necessarily incurred. The court determined that the loan was necessary to pay the estate tax liability because one of the decedent's children prevented loans being made by or dividends from being distributed from the LLC.
Holliday: In Estate of Holliday,18 the Tax Court ruled that assets the decedent transferred to a partnership were includible in the decedent's gross estate because the decedent retained the right to the beneficial enjoyment of the property transferred to the partnership.
The decedent acquired significant assets from her late husband when he died in 1999 and was also independently wealthy. In 2003, her two sons moved her to a nursing facility. On Nov. 30, 2006, the decedent formed three entities: (1) a partnership; (2) an LLC, a general partner of the partnership; and (3) an irrevocable trust. On Dec. 6, 2006, the decedent: (1) funded the partnership with nearly $6 million of marketable securities—a portion for the 99.9% limited interest and a portion on behalf of the LLC as 0.1% general partner; (2) sold her interest in the LLC to her sons for $6,000, without discount or adjustment, shifting legal control of the partnership to the sons who, as general partners, had the sole rights and powers to participate in the partnership under the partnership agreement; and (3) gifted 10% of the partnership's limited partnership interests to the trust.
Between the date of these transactions and the decedent's death, the partnership made only one distribution of $35,000 pro rata to each partner, as determined by the LLC under the partnership agreement. Section 5 of the partnership agreement gave the general partner the power to make periodic, regular distributions if the partnership had funds exceeding its current operating needs. On Jan. 7, 2009, the decedent died owning an 89.9% limited partner interest in the partnership. The decedent's estate chose to elect the alternative valuation date, on which the FMV of the interest in the partnership was just over $4 million. After discounts, the executor listed the partnership interest at $2.4 million on the decedent's estate tax return. The IRS issued a notice of deficiency for $785,019, concluding that because the decedent retained the right to the enjoyment of the property transferred to the partnership, the property was includible in her estate.
The Tax Court held for the IRS, determining that Sec. 2036(a) applied for three reasons. First, the decedent made an inter vivos transfer of $6 million of property in 2006. Second, the decedent retained an interest in the transferred assets because (a) as a limited partner she was entitled to the income from the assets, and (b) at trial, it was clear that the decedent's sons, as general partners, impliedly agreed with the decedent that if the decedent needed funds, the sons would have ensured that the partnership would make a distribution to her. Third, the decedent's transfer was not a bona fide sale because the sons failed to prove any actual, significant nontax motivations for creating the partnership.
The court rejected assertions that the decedent initiated the aforementioned structure to protect assets from seizure as a judgment in litigation, to protect assets from undue influence, and to preserve assets for the benefit of the sons and their heirs—stating that trust structures similar to those in place for the family were sufficient for these purposes.
The Tax Court also found that (1) the decedent stood on both sides of the transaction; (2) no meaningful bargaining between the decedent and the sons occurred as to the purchase of the LLC; and (3) the partnership failed to maintain books and records other than brokerage statements and ledgers. As a result of these findings, the court held that the $6 million the decedent transferred to the partnership was fully includible in her gross estate and the other issues were moot.
This case did not have as many bad facts compared with some other FLP cases where parties made deathbed transfers, transferred all assets to a single entity, commingled personal assets and FLP assets, used an FLP as a personal or family bank, and/or ignored all FLP formalities. It seems the court could have gone either way on this case. Query whether it would have been more appropriate to interpret the distribution power as a traditional partnership provision controlled by general partners, instead of reading into it a theoretical possibility that the decedent could have attempted to have the sons permissively allow their mother to treat the partnership as her personal account.
Pulling: In Estate of Pulling,19 the Tax Court held that it was not appropriate to combine an estate's property with other property the decedent had an interest in through a land trust to determine its value for federal estate tax purposes.
At the time of the decedent's death, he owned a 28% interest in a land trust (LT), which owned two parcels of land that were used primarily to cultivate citrus fruit. Several of the decedent's family members, along with a business partner, held significant minority interests in LT. LT had previously declined to sell its land to a residential developer. The decedent also owned three other parcels of land (Parcels 3, 4, and 5) adjacent to the LT land, which were undeveloped because they were inaccessible and had peculiar physical dimensions. The decedent had used Parcels 3, 4, and 5 as a tree and plant nursery.
In 2004, when the decedent gifted part of his interest to various family members, he had the parcels valued. That report treated LT's property and Parcels 3, 4, and 5 as if they were a single tract. In 2011, the estate had the parcels valued separately, which resulted in lower appraisals. Both appraisals were submitted with the decedent's estate tax return. The IRS argued that the properties should be valued as a single tract.
The Tax Court started by noting value is determined by finding the price that a willing buyer and willing seller would agree to because each would presumably want to achieve maximum economic advantage. It further noted that a property's FMV may reflect not only its current use but also one to which it may be readily converted. If a special or higher use of the land is only possible when it is combined with other parcels, the special use may be considered if there is a reasonable possibility that the land will be combined in the near future. The burden of proof is on the party arguing to combine the properties.
Both the estate's and the IRS's experts agreed that if Parcels 3, 4, and 5 could be combined with LT's property, then residential development of the whole would be the highest and best use of the land. However, the parties disagreed over whether it was appropriate to consider a use that requires combining a property to be valued with another property not under common ownership. The IRS argued that assemblage was likely because of the economic benefits of assemblage and the ties between the decedent and the various stakeholders in LT.
The Tax Court disagreed. First, the court noted that LT had declined at least one prior offer to sell its property as part of a residential development, suggesting that LT's stakeholders were not interested in selling the property just because it would have been in their economic interests. Further, both experts testified that they would not recommend that a hypothetical buyer of Parcel 3, 4, or 5 purchase the land as a possible investment. Second, the court stated that there was no evidence to support the proposition that other members of the decedent's family would be reasonably likely to combine the properties. The court reasoned that just because some of LT's stakeholders were related to the decedent was not enough to conclude that they would be likely to combine the properties.
After holding that assembly of the estate's property with LT's property was not reasonably likely, and thus, for purposes of valuation, residential development of the property with the LT's property as a single parcel was not the highest and best use of the estate's property, the court valued Parcels 3, 4, and 5 as separate parcels based on the 2011 appraisal. The IRS contended that the court should adopt the estate's 2004 appraisal values because the 2004 appraisal took into account additional value provided to the estate's property by the possibility of assemblage. The court found that the IRS's theory was too speculative and not supported by the record in the case.
1Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41.
2Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113.
3See, e.g., IRS Letter Ruling 201325018.
4Cathy Hughes, Treasury Department attorney-adviser, in remarks to a meeting of the American Bar Association Sections of Taxation and Real Property (Freda, "Windsor Changes Law for Estate, Gift Tax Treatment, Treasury Official Says," BloombergBNA Daily Tax Report, p. G-8 (Sept. 24, 2013)).
6Heroes Earnings Assistance and Relief Tax Act of 2008, P.L. No. 110-245.
7Steinberg, 145 T.C. No. 7 (2015).
8Estate of Edward Redstone, 145 T.C. No. 11 (2015).
9Redstone, T.C. Memo. 2015-237.
10Estate of Donald Woelbing, T.C. Docket No. 30261-13 (stipulated decision entered March 25, 2016), and Estate of Marion Woelbing, T.C. Docket No. 30260-13 (stipulated decision entered March 28, 2016).
11See Karmazin, T.C. Docket No. 2127-03 (filed Feb. 7, 2003).
12Wandry, T.C. Memo. 2012-88.
13REG-127923-15, 81 Fed. Reg. 11486.
14T.D. 9757, 81 Fed. Reg. 11431.
16Brewster v. Gage, 280 U.S. 327 (1930).
17Estate of Purdue, T.C. Memo. 2015-249.
18Estate of Holliday, T.C. Memo. 2016-51.
19Estate of Pulling, T.C. Memo. 2015-134.
|Justin Ransome is a partner in the National Tax Department of Ernst & Young in Washington. He was assisted in writing this article by members of Ernst & Young's National Tax Department in Private Client Services—David Kirk, Marianne Kayan, Jennifer Einziger, Ashley Weyenberg, Caryn Gross, John Fusco, Shawntel Randi,and Ankur Thakkar. For more information about this article, contact email@example.com.