Recent developments in estate planning: Part 1

This is the first in a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and fiduciary income tax between June 2017 and May 2018. Part 1 discusses legislative, gift, and estate tax developments. Part 2 will discuss GST tax and trust tax developments as well as inflation adjustments for 2018.

Tax Cuts and Jobs Act

Although the title of P.L. 115-97 was stripped from the legislation due to a procedural move in Congress, it has been commonly referred to as the Tax Cuts and Jobs Act (TCJA). While the TCJA made sweeping changes to the income tax chapter of the Internal Revenue Code, it left the gift, estate, and GST tax sections of the Code relatively untouched.

Trusts and estates

Many of the changes to the income tax provisions for individuals (generally effective for tax years 2018 through 2025) also affect trusts and estates, which are generally treated as individuals unless otherwise provided in Subchapter J.

The maximum income tax rate for trusts and estates is now 37% and is reached when the trust has taxable income over $12,500 in 2018.¹

The deduction under Sec. 67(a) for miscellaneous itemized deductions has been suspended.² However, in Notice 2018-61, Treasury and the IRS announced their intention to issue regulations clarifying that estates and nongrantor trusts may continue to deduct expenses described in Sec. 67(e) paid or incurred in the administration of an estate or a trust (that would not have been incurred if the property had not been held in the estate or trust), as well as deductions allowable under Secs. 642(b) (regarding the personal exemption) and 651 and 661 (both regarding distribution deductions). There had been some confusion as to whether the suspension of miscellaneous itemized deductions also suspended deductions provided for trusts and estates in Sec. 67(e). The notice (released July 13, 2018) puts to rest this uncertainty.

Also under the TCJA for the applicable period, the deduction under Secs. 164(a)(1)—(3) for state and local, personal property, and foreign taxes is limited to $10,000, and foreign real property taxes may not be deducted unless paid or accrued in carrying on a trade or business or for the production of income.³

Trusts and estates are eligible for the 20% deduction for qualified business income under new Sec. 199A. According to the Joint Explanatory Statement of the Committee of Conference, rules similar to (now repealed) Sec. 199 apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital.⁴

Estate, gift, and GST taxes

Although many predicted that the estate, gift, and GST tax regimes would be repealed in the tax reform effort, the TCJA does very little to these regimes except to exempt a number of taxpayers from them due to the size of their estates. Under the TCJA, for decedents dying, or gifts made, after Dec. 31, 2017, and before Jan. 1, 2026, the basic exclusion amount was increased from $5 million to $10 million, indexed for inflation occurring after 2011. For 2018, the basic exclusion amount is $11,180,000.

The TCJA also addresses the possible “clawback” issue in case a taxpayer uses up his or her applicable exclusion amount during life, the TCJA sunsets, and the basic exclusion amount returns to $5 million, indexed for inflation. Readers may remember that this same issue arose when the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act)⁵ temporarily increased the applicable exclusion amount through 2012 to $5 million and, but for this provision being made permanent by the American Taxpayer Relief Act of 2012,⁶ would have sunset, returning the applicable exclusion amount to $1 million. While the TCJA does not resolve the clawback issue, newly added Sec. 2001(g)(2) directs Treasury to issue regulations to address any difference between the applicable basic exclusion amount in effect at the time of the decedent’s death and with respect to any gifts made by the decedent.

Surprisingly, the TCJA does not change the top estate tax rate of 40%, continues to allow “portability” of a deceased spousal unused exclusion (DSUE) amount, and does not change the basis step-up rules in Sec. 1014 — all provisions that seemed likely to change under early blueprints put forth by Congress and the president. As previously stated, the change in the basic exclusion amount will exempt more estates from paying estate tax. However, for taxpayers who will still have taxable estates, estate planning will continue much in the same way it always has, with the exception that more modest estates subject to the estate tax might focus more on maximizing the income tax benefits that may come from the increase in the applicable exclusion amount, such as having assets transferred to someone in an older generation to get a step-up in basis without causing an estate tax liability to the older generation.

Gift tax

Purchase of remainder interest in trust

In Chief Counsel Advice (CCA) 201745012, the IRS Office of Chief Counsel determined that a donor’s purchase of the remainder interests of two trusts constituted gifts and did not increase the decedent’s gross estate for estate tax purposes because the donor retained an interest in the trusts under Sec. 2036.

The donor formed an irrevocable discretionary trust for the benefit of his spouse and issue. The trust was to terminate on the later of the death of the donor or that of his first spouse, when the principal and any accumulated income were to be distributed outright to the donor’s issue per stirpes. The donor’s first spouse predeceased him.

The donor then formed two grantor retained annuity trusts (GRATs), both of which were for the benefit of the donor and his issue. An annuity from both GRATs was payable to the donor for the term of each trust, with the remainder payable under the terms of the discretionary trust. The donor purchased the remainder interest of the GRATs from the trustees of the discretionary trust with two unsecured promissory notes. The next day, the donor died.

The donor’s gift tax return reported the purchase of the remainder interests in the GRATs as nongifts, asserting that the donor received adequate and full consideration in money or money’s worth. The donor’s estate tax return deducted the value of the outstanding promissory notes payable to the trustees of the discretionary trust as claims against the estate.

The advice considered two issues: (1) whether the donor’s deathbed purchase of the remainder interests constituted adequate and full consideration in money or money’s worth for gift tax purposes, and (2) whether the notes given for the remainder interests were debt deductible by the estate for estate tax purposes.

Regarding the first issue, the IRS noted that under Sec. 2512(b), property transferred for less than an adequate and full consideration in money or money’s worth is a gift to the extent the value of the property exceeds the value of the consideration. In Wemyss,⁷ the Supreme Court determined that adequate and full consideration for gift tax purposes is that which replenishes or augments the donor’s taxable estate. The IRS determined in the CCA that adequate and full consideration was not provided. The donor’s gross estate was not increased by the purchase of the remainder interests because the remainder interests were already includible in the donor’s gross estate under Sec. 2036 (which includes in a decedent’s gross estate transfers in which the decedent retained a life estate). Thus, the remainder interests were not received in exchange for full and adequate consideration. The IRS concluded that the notes were a depletion of the donor’s estate without a corresponding accretion and, thus, the notes were gifts to the discretionary trust.

Regarding the second issue, the IRS noted that Sec. 2053(c)(1)(A) allows a deceased’s estate a deduction for claims against the estate, unpaid mortgages, or any indebtedness, when founded on a promise or agreement, to the extent that they were contracted in a bona fide transaction for an adequate and full consideration in money or money’s worth. The companion case to Wemyss, Merrill v. Fahs,⁸ determined that the gift tax and estate tax should be considered “harmoniously,” and, thus, “adequate and full consideration” should have the same meaning for estate tax as for gift tax. Therefore, the Supreme Court determined, adequate and full consideration for estate tax purposes is that which replenishes or augments the donor’s taxable estate. The IRS in the CCA determined that the debt was not the result of a bona fide transaction for full and adequate consideration because the property acquired with the notes did not increase the decedent’s gross estate. As a result, the notes were not deductible on the decedent’s estate tax return under Sec. 2053.

Rev. Rul. 98-8 reached a similar conclusion regarding a surviving spouse’s purchase of a remainder interest in a qualified terminable interest property trust. In that ruling, the transaction was considered a gift of the remainder interest, under two separate theories: First, the commutation of the trust by dividing the trust property between the remainderman and life beneficiary was a taxable disposition by the spouse of the qualifying income interest, resulting in a gift under Sec. 2519 equal to the value of the remainder interest. Second, because the spouse acquired an asset (the remainder interest) that would have been included in the spouse’s gross estate in any event under Sec. 2044, the receipt of the remainder interest did not constitute adequate and full consideration for gift and estate tax purposes.

Part gift, part sale

In Fiscalini,⁹ the Tax Court held that a taxpayer had gain only to the extent of discharged liabilities on the sale of his home to his parents because the transfer was a part gift and part sale.

On March 31, 1993, the taxpayer and his parents purchased a home in California for $274,312. The taxpayer’s parents paid $40,000 for their interest in the home, and the taxpayer financed the remaining $234,312 for his portion of the home. In 2003, the taxpayer’s parents gifted their interest in the home to the taxpayer. From the time the home was purchased until Aug. 1, 2007, the taxpayer made approximately $50,000 in improvements to the home and refinanced it multiple times, totaling $664,048 in loans owed on the home. In 2007, the taxpayer’s parents purchased the home from the taxpayer for the amount of the outstanding loans on it, $664,048. The fair market value (FMV) of the home at the time of the sale was $975,000. The taxpayer incurred settlement costs of $16,751 on the sale.

The taxpayer did not file an income tax return for 2007 until 2013. The IRS subsequently issued a notice of deficiency stating that the taxpayer had to recognize $975,000 of long-term capital gain on the sale of the home. The following issues were before the Tax Court: (1) the taxpayer’s adjusted basis in the home when the sale was made to his parents, and (2) the amount realized from the sale of the home.

Under Sec. 1001(a), gain from the sale of property is the amount realized less the adjusted basis of the property. Generally, under Sec. 1012(a), the basis of property is its cost. Property acquired by gift has the same basis as it does in the hands of the donor under Sec. 1015(a). Under Sec. 1016(a)(1), expenditures made to improve the property should result in a proper adjustment to basis. Under Tokarski,¹⁰ testimony is not enough to establish the cost of improvements. Under Sec. 1001(b), the amount realized is the sum of any money received plus the FMV of any property received. Regs. Sec. 1.1001-2(a)(1) provides that, generally, the amount realized from the sale of property includes the amount of liabilities from which the transferor is discharged as a result of the sale. Under Regs. Sec. 1.1001-1(e)(1), where a transfer of property is in part a sale and in part a gift, the transferor has gain to the extent that the amount realized exceeds the transferor’s adjusted basis in the property.

The Tax Court determined that the taxpayer’s basis in the property was the sum of his purchase price, $234,312, and the basis that his parents had in the property, $40,000, when they gifted him their interest in the property in 2003, for a total adjusted basis of $274,312. The taxpayer argued that his adjusted basis in the property should be increased by an additional $50,000 because of the improvements he made to it. However, the taxpayer was unable to provide any other evidence besides his testimony, and, therefore, the court determined that the taxpayer’s basis in the property would not be increased by $50,000.

The Tax Court next determined that because this transaction was a part gift, part sale from the taxpayer to his parents, the gain would be the amount realized less the adjusted basis. The amount realized was the discharged loan amounts totaling $664,048. The taxpayer did not receive any cash in addition to the discharged loans, and, thus, there was no additional amount realized, even though the FMV of the home was $975,000. After taking into consideration the settlement costs, the amount realized was $647,297. The amount of capital gain, the court stated, was $372,585.¹¹ Taking into account the $250,000 exclusion from gross income under Sec. 121 for the principal residence, the long-term capital gain realized by the taxpayer for the home was stated in the slip opinion as $122,585.¹²

Although not specifically stated in the opinion, the resulting gift to the taxpayer’s parents was $327,703 ($975,000 (FMV of the house) – $647,297 (amount realized)).

Estate tax

Simplified method to elect portability

Rev. Proc. 2017-34 provides a simplified method to obtain an extension of time under Regs. Sec. 301.9100-3 to file an estate tax return to elect portability of the DSUE amount under Sec. 2010(c)(5)(A). The revenue procedure applies to estates not normally required to file estate tax returns because they fall below the Sec. 6018(a) filing threshold.

Before 2011, married couples could not preserve any unused lifetime applicable exclusion amount of the first-to-die spouse. The 2010 Tax Relief Act amended Sec. 2010(c) to allow portability of the applicable exclusion amount between spouses. When a spouse died in 2011 or 2012, the surviving spouse could add to his or her own applicable exclusion amount the deceased spouse’s unused applicable exclusion amount available at death. This provision was set to expire on Dec. 31, 2012, but the American Taxpayer Relief Act of 2012 made portability permanent.

In June 2012, the IRS issued temporary and proposed regulations¹³ on the requirements for electing portability of a DSUE amount. The IRS issued final regulations¹⁴ in June ٢٠١٥ on the estate and gift tax applicable exclusion amount, as well as the requirements for electing portability of a DSUE amount to the surviving spouse. Largely adopting the regulations issued in ٢٠١٢, the final regulations apply to estates of decedents dying on or after June ١٢, ٢٠١٥.

Sec. 2010(c)(5) provides that the executor of the estate of the deceased spouse must elect portability of the DSUE amount on a timely filed estate tax return and that the return must include a computation showing how the amount was calculated. Regs. Sec. 20.2010-2(a)(1) provides that the due date for an estate tax return on which a portability election is made is nine months after the date of death or the last day of an extension period, if an extension of time to file was obtained. Regs. Sec. 20.2010-2(a)(1) also provides that an extension of time to elect portability will not be granted under Regs. Sec. 301.9100-3 to an estate that must file an estate tax return under Sec. 6018(a) without regard to the portability election. However, an extension to elect portability under Sec. 2010(c)(5)(A) may be available to an estate that is not otherwise required under Sec. 6018(a) to file an estate tax return.

Rev. Proc. 2014-18 provided a simplified method until Dec. 31, 2014, for obtaining an automatic extension of time to elect portability for estates that were not otherwise required to file an estate tax return. After that relief expired, the IRS issued numerous private letter rulings granting extensions of time to elect portability for estates not otherwise required under Sec. 6018(a) to file an estate tax return.

Rev. Proc. 2017-34 stated that continuing relief was needed for estates that are not otherwise required to file an estate tax return, because the IRS had received a considerable number of requests for an extension of time to elect portability since Dec. 31, 2014, that had placed a significant burden on the Service. Therefore, the revenue procedure provided a simplified method for estates that are not otherwise required to file an estate tax return to obtain an extension of time to elect portability, for a period ending on the later of Jan. 2, 2018, or the second anniversary of the decedent’s death. After this period expires, an estate will be able to seek relief by requesting a private letter ruling under Regs. Sec. 301.9100-3.

The simplified method provided in Rev. Proc. 2017-34 may be used if: (1) the decedent (a) was survived by a spouse, (b) died after Dec. 31, 2010, and (c) was a citizen or resident of the United States on the date of death; (2) the executor is not required under Sec. 6018(a) to file an estate tax return without regard to the portability election; (3) the executor did not file an estate tax return within the time required under Regs. Sec. 20.2010-2(a)(1); and (4) the executor follows the requirements for relief set out in Section 4.01 of the revenue procedure.

To meet the requirements for relief under Section 4.01, the executor must: (1) file a complete and properly prepared estate tax return on or before the later of Jan. 2, 2018, or the second anniversary of the decedent’s death; and (2) write at the top of the Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, “Filed Pursuant to Rev. Proc. 2017-34 to Elect Portability Under Section 2010(c)(5)(A).” If an estate that has obtained relief under Rev. Proc. 2017-34 is later determined to have been required to file an estate tax return under Sec. 6018(a) based on the value of the gross estate (and taking into account any taxable gifts), the grant of an extension is deemed null and void.

If the decedent’s estate is granted relief under Rev. Proc. 2017-34 and the estate tax return is considered timely filed for purposes of electing portability, the decedent’s DSUE amount is available to his or her surviving spouse or the spouse’s estate for application to the surviving spouse’s transfers made on or after the decedent’s date of death, in accordance with the rules under Regs. Secs. 20.2010-3 and 25.2505-2. However, if the increase in the surviving spouse’s applicable exclusion amount attributable to the addition of the decedent’s DSUE amount causes the surviving spouse or his or her estate to overpay gift or estate tax, no claim for credit or refund may be made if the Sec. 6511(a) time for filing a claim for credit or refund of a tax overpayment has expired. Rev. Proc. 2017-34 includes a provision enabling an estate to file a protective claim for credit or refund of tax in anticipation of relief under the revenue procedure and provides three examples illustrating how the revenue procedure is to be applied.

Although the simplified method provided in the revenue procedure is designed to free up resources at the IRS to focus on more substantive matters, it also has the effect of relieving an estate of the burden of having to request a private letter ruling to get an extension of time to make a portability election — at least, if the estate realizes within two years of the decedent’s death that it may make the election by filing an estate tax return. If the estate fails to realize this omission within two years of the decedent’s death, it can still seek a private letter ruling to obtain relief for an extension of time to make a portability election. This revenue procedure, however, does not provide any relief for estates that are otherwise required to file a return under Sec. 6018(a).

Credit for gift tax paid

In Estate of Sommers,¹⁵ the Tax Court held that an estate could not deduct under Sec. 2053 the gift tax paid by three nieces who had received valid gifts from their uncle in the year before he died, and that no estate tax could be apportioned to the nieces under New Jersey law.

In 2001, the decedent, Sheldon C. Sommers, sought legal advice because he wanted to give his three nieces certain works of art from his collection and minimize his own tax liability with regard to the transaction. Following his attorneys’ advice, Sommers transferred the artwork to a limited liability company (LLC) formed for this purpose and gifted units in the LLC to his nieces in two stages, one at the end of 2001 and the second at the beginning of 2002. Sommers and his nieces executed two sets of gift and acceptance agreements in December 2001 and January 2002; the 2002 agreements were ultimately amended with a provision stating that the donees agreed to pay any gift tax due as well as any penalties and interest assessed (commonly referred to as “net gifts”). The agreements were silent regarding any apportionment of liability for federal estate tax resulting from the gifts.

Sommers’s last will, executed in April 2002, directed the executrix, his ex-wife, to pay all of his debts and expenses to settle the estate and bequeathed to her whatever remained of the estate after those debts were paid. Sommers remarried his ex-wife before he died. The nieces had not yet paid the gift tax on their uncle’s gift by the date of his death on Nov. 1, 2002. Following Sommers’s death, his wife filed an estate tax return claiming a deduction under Sec. 2053 for the amount of the unpaid gift tax.

In an earlier Tax Court case involving the same estate,¹⁶ the parties had disputed when the gifts were actually complete — the estate contended they were not complete until the gift documents were ultimately completed in April 2002, but the IRS argued the gifts were complete when Sommers transferred units in the LLC to his nieces in December 2001 and January 2002. The Tax Court ruled for the IRS. The parties subsequently stipulated that Sommers’s gift tax liabilities were zero for 2001 and $273,990 for 2002, and the nieces then paid the gift tax.

In the subsequent case, the parties stipulated that the amount of the gift tax was includible in Sommers’s gross estate under Sec. 2035(b), which includes in a decedent’s gross estate the amount of gift tax paid on gifts made within three years of death. The parties disagreed on whether a deduction was allowable under Sec. 2053(a) for the amount of the gift tax because it was paid after Sommers’s death.

Deductibility of gift tax

When a donee agrees to pay the gift tax on a gift he or she receives, the taxable gift is determined by calculating the difference between the total value of the property transferred and the gift tax on the “net” gift — generally, the full value of the transferred property divided by the sum of the applicable tax rate plus 1. A net gift is essentially a part sale, part gift, the sale part being the amount of the gift tax owed by the donor and paid by the donee, and the gift part being the remaining amount of the transfer.

The Sommers estate argued the deduction was permitted because the obligation to pay the gift tax remained on the donor, regardless of who paid it. The estate also acknowledged that allowing the gift tax deduction under Sec. 2053 would eliminate the $273,990 gift tax add-back that takes place under Sec. 2035(b) on a dollar-for-dollar basis. The IRS asserted the gift tax payment was not deductible because the nieces (who intervened in both cases) received nothing from the estate and, therefore, did not pay the gift tax as beneficiaries of their uncle’s estate. Further, the IRS asserted that allowing a deduction for a liability that would not reduce the net amount passing to Sommers’s other heirs would subvert the purposes of Sec. 2035.

The Tax Court agreed with the IRS, reasoning that because the gift tax was subject to reimbursement from the nieces, no deduction was allowed. The court emphasized that the key issue when considering the deductibility under Sec. 2053(a) of gift tax owed on a net gift, as opposed to inclusion of that amount in a decedent’s gross estate under Sec. 2035(b), is not whether the decedent (or his or her estate) served as the ultimate source of the funds used to pay the liability but when the decedent parted with that value.

Sommers had effectively provided his nieces with the funds to pay the gift tax before he died because, for each niece, the portion of the value of the units transferred in 2002 that was ultimately determined to constitute a taxable gift was less than the total value of those gifts, by the amount of the gift tax. The court noted that Sommers made these gifts before he died, withdrawing from his potential estate not only the value of the taxable gifts but also the amount of the tax on the gifts. It further concluded that whether the gift tax was paid before or after Sommers’s death should be of no consequence to the allowance of a deduction by the estate.

Sommers’s estate had a reasonable argument that the unpaid gift tax liability should have been a debt of the estate under Sec. 2053. Sec. 2501 places the responsibility for paying the tax on the donor of a gift regardless of whether the donor has entered into an agreement with a donee requiring the donee to pay the tax. It is the donor who is required to file a gift tax return and remit the payment of gift tax with the return. Thus, it would seem reasonable that if Sec. 2501 imposed an obligation on a donor to pay tax, and the tax had not been paid at the time of death, the unpaid tax would be a claim against the decedent’s estate and deductible under Sec. 2053. However, the court relied on long-standing precedent that a claim against an estate is deductible only to the extent that it exceeds a right to reimbursement to which its payment would give rise. The court determined that Sommers’s gift tax liability was fully reimbursable from his nieces and, therefore, not deductible under Sec. 2053. Barring such reimbursement, the gift tax liability would have been deductible under Sec. 2053.

Effect of debts and expenses on marital deduction

In one of the estate’s motions for summary judgment, it claimed it was entitled to a marital deduction equal to the value of Sommers’s nonprobate property that Sommers’s wife received that was exempt from the estate’s debts and expenses under New Jersey law.

The Tax Court denied the estate’s motion, explaining that a determination of whether the estate was entitled to a marital deduction for the nonprobate property turned on the factual question of the extent to which assets otherwise exempt from claims against the estate were used to pay the reported debts and expenses, and the record before the court was insufficient to make this determination.

Apportionment of estate tax

If necessary, federal estate tax can be collected from beneficiaries who receive, or hold on the decedent’s date of death, certain property included in the estate (commonly referred to as “apportionment”). Similarly, state apportionment statutes generally provide, in the absence of a contrary direction from the testator, for ratable allocation of the estate tax among all nonexempt recipients of property by reason of the testator’s death.

Beginning in 1976, under Sec. 2052, the federal estate and gift taxes have been combined and are cumulative in nature (i.e., the amount of taxable gifts made during a decedent’s lifetime is brought back into the decedent’s estate tax calculation to determine the decedent’s estate tax liability). New Jersey’s apportionment statute dates to 1950 and has not been amended to consider apportionment when lifetime gifts affect a decedent’s estate tax liability, nor have any judicial decisions addressed the issues.

Under New Jersey’s apportionment statute, tax is apportioned among the fiduciary and each transferee with an interest in the gross estate, unless the testator directed otherwise in the will or a nontestamentary instrument. Whether, in Estate of Sommers, any of the estate tax could be apportioned to the nieces depended upon whether LLC units transferred to the nieces were included in computing the estate tax, making them “transferees” under the New Jersey statute.

Both the estate and the IRS contended that the estate tax should be apportioned to the nieces under state law. The nieces opposed the apportionment motion, arguing that: (1) gift tax clawbacks do not constitute property of the transferee within the meaning of the New Jersey apportionment statute, and (2) apportioning to them any of the estate tax liability would be inconsistent with Sommers’s intent.

The Tax Court interpreted the New Jersey apportionment statute as providing for the apportionment of federal estate tax only to transferees who receive nonprobate property included in a decedent’s gross estate. It was unwilling to conclude that New Jersey courts were likely to take the lead of other states’ courts and essentially read into the apportionment statute the requirement that donees of lifetime gifts be considered “transferees” for New Jersey apportionment purposes.

The court noted that the IRS had not identified any property in the decedent’s gross estate that the nieces had received or from which they had benefited — pointing out that the LLC units were the only property the nieces had received from their uncle, and that, although the gift tax paid on those gifts was included in the gross estate, the actual units were not. Because the LLC units the nieces received were not included in the gross estate and, therefore, were not included in calculating the estate tax liability, the court concluded that the nieces did not, under New Jersey law, constitute transferees to whom estate tax liability could be apportioned.

Remainder interest in a trust

In Badgley,¹⁷ a district court granted the IRS’s motion for summary judgment and held that, under Sec. 2036, a GRAT was properly included in the estate of a decedent. The court also held Regs. Sec. 20.2036-1(c)(2)(i), which requires transferred GRAT property to be included in a decedent’s gross estate, to be reasonable and valid under Chevron.¹⁸

In 1976, brothers Donald Yoder and H. Frank Yoder III created a partnership to manage several parcels of California real estate. Patricia Yoder was married to Donald. In 1982, Patricia and Donald Yoder created a revocable trust, which held Donald Yoder’s interest in the partnership. Donald Yoder died in 1990. Patricia Yoder then became a one-half partner in the partnership.

On Feb. 1, 1998, Patricia Yoder created a GRAT, which she funded with her one-half partnership interest in the partnership. The GRAT provided that she was to receive annual annuity payments for the lesser of 15 years or her prior death (paid quarterly), equal to 12.5% of the date-of-gift value of the property transferred to the GRAT. Under the GRAT, the partnership interest was to pass to Yoder’s two daughters on the expiration of the annuity payments. Yoder died on Nov. 2, 2012, before the expiration of the GRAT term.

Yoder’s estate tax return was filed and reported a total gross estate of $36,829,057, including the value of the assets held in the GRAT, and reported taxes due of $11,187,475, which the estate paid. The estate then filed a claim seeking a refund from the IRS of $3,810,004 in estate tax alleged to have been overpaid by the estate as a result of the inclusion of all the assets of the GRAT. The IRS did not advise on the allowance or disallowance of the refund claim within six months of its filing, and the estate sued for a refund in district court. In the suit, the estate filed a motion for summary judgment on two bases: (1) Sec. 2036(a)(1) did not apply to the GRAT, and (2) Regs. Sec. 20.2036-1(c)(2)(i) was overly broad and invalid to the extent that it applied to the GRAT.

Pursuant to Sec. 2036(a), an individual’s gross estate includes property a taxpayer transferred during life if he or she retained the right to possess or enjoy the property or its income. Regs. Sec. 20.2036-1(c)(2)(i) requires that all or part of property transferred to a GRAT be included in a decedent’s gross estate under Sec. 2036 where the decedent retains an annuity interest and dies before the expiration of the GRAT term. The portion of the trust assets includible in the decedent’s gross estate is the portion that is necessary to generate sufficient income to satisfy the retained annuity.

The district court found that, based on the Supreme Court’s pragmatic approach to Sec. 2036’s operative language, Yoder’s right to a fixed-annuity payment from the GRAT brought her transferred property within the meaning of that section. In Helvering v. Hallock,¹⁹ which dealt with the predecessor of Sec. 2036, the Court agreed that the IRS correctly calculated the gross estate tax of several decedents to include trust properties transferred inter vivos. The Court stated that the grantor’s reservation of any interest, however remote, was sufficient to bring the conveyance within the Code’s “possession or enjoyment” language.

In Church’s Estate,²⁰ which also dealt with the predecessor to Sec. 2036, the Court extended the “possession or enjoyment” language to apply to any transfer to a trust, except a bona fide transfer in which the settlor gives up all of his or her rights in the transferred property. Looking to substance and not merely form, the Court concluded that the decedent in that case retained for himself until death a most valuable property right in certain stocks, the right to get and to spend their income.

Finally, in Spiegel’s Estate²¹ (also dealing with the predecessor to Sec. 2036), the Court reaffirmed that the provision’s applicability hinged primarily on the nature and operative effect of the trust transfer. The Court emphasized that the settlor’s intent to retain a reversionary interest did not bear on the “possession or enjoyment” inquiry. Rather, the grantor’s retention of any “absolute or contingent” “present or future interest” vitiated the complete kind of transfer required to show that the grantor had certainly and irrevocably parted with his possession or enjoyment. The Court emphasized that any requirement less than that would facilitate circumvention of the section and, thus, frustrate Congress’s legislative intent.

The district court in Badgley found that the facts showed that: (1) Yoder funded the GRAT with her one-half interest in the partnership; (2) the partnership properties were placed into the GRAT; (3) Yoder’s transfer of her one-half interest was not a bona fide sale, and no consideration was given; (4) the income generated by the partnership interest each year was greater than Yoder’s annual annuity; and (5) Yoder died before the GRAT’s expiration. The court found that the estate did not dispute, and there was no evidence to show, that any of the three properties constituting the original trust corpus were ever sold to fund Yoder’s annuity. As a result, her annuity necessarily drew either from the GRAT’s accumulated income (i.e., the principal) or the current income that flowed into the GRAT each year from the rents received through the partnership.

The district court found the Third Circuit’s decision in McNichol’s Estate²²persuasive, supporting a finding that Yoder’s annuity provided her with some possession, enjoyment, or right to income within the meaning of Sec. 2036. In McNichol’s Estate, the Third Circuit considered whether several income-producing real estate properties were properly included in a decedent’s gross estate where the decedent had orally transferred the properties to his children, and his children understood that the decedent should retain for his lifetime the income from the real estate. The Third Circuit held that the decedent’s receipt of rents from the properties in the trust constituted enjoyment of the transferred properties. The Third Circuit also found that “enjoyment” was synonymous with substantial present economic benefit. The Third Circuit read the Church’s Estate opinion as constituting a sweeping and forthright declaration that technical concepts pertaining to the law of conveyancing could not be used as a shield against the impact of death taxes when, in fact, possession or enjoyment of the property by a transferor (and more particularly, his or her enjoyment of the income from the property) ceased only with his or her death. According to the district court, this reading of Church’s Estate aligned with the IRS’s argument.

The district court rejected the estate’s contention that Yoder could have no “right to income” because she did not have an ascertainable and legally enforceable power to receive income from the transferred property. The estate highlighted that the partnership’s income fluctuated, while Yoder’s annuity remained constant, but the court determined that this argument failed. As a threshold, the argument assumed that income and annuity were distinct for the purpose of Sec. 2036, but the courts had held otherwise. Also, the case law the estate relied on for the interpretation of “right” was not applicable to Sec. 2036(a)(1).

Finally, the court noted that the estate admitted that an implied right to income can exist when annuity payments are no more than disguised payments of income. The court found that this implied right existed here because (1) Yoder created the original trust corpus with her one-half share in the partnership, including the three multitenant parcels of real estate; (2) there was no evidence that any of these properties were ever sold off; and (3) the partnership’s income was always greater than Yoder’s annuity payment. The income from the partnership, whether accumulated or current, thus always funded Yoder’s annuity. And Yoder expressly reserved that annuity right in the GRAT.

The district court rejected the estate’s argument that, apart from whether Yoder enjoyed a right to income from the GRAT, her fixed annuity could not constitute some other possession or enjoyment. Specifically, the estate asserted that enjoyment was equivalent to the right to income, which Yoder lacked, and that “possession” applied only where the property owner continued to possess or use the property for the remainder of his or her life. However, the court determined that Yoder did enjoy a right to income within the meaning of Sec. 2036(a)(1). And even if Yoder lacked a right to income, she still enjoyed the property, given her access to current and/or accumulated income from her interest in the partnership.

To determine whether Regs. Sec. 20.2036-1(c)(2)(i) was valid, the district court analyzed it under the two-part Chevron test. Under this approach, a court determines: (1) if Congress has directly addressed the question at issue; and (2) if not, whether the agency’s rule is a permissible interpretation (i.e., not arbitrary or capricious in substance, or manifestly contrary to the statute). Here, the parties agreed that Sec. 2036 did not expressly address whether annuity payments constitute some possession, enjoyment, or right to income from the transferred property, so the court proceeded directly to step 2.

Applying the second part of the Chevron test, the district court found that Regs. Sec. 20.2036-1(c)(2)(i) was a reasonable interpretation of Sec. 2036. In drafting the regulation, the IRS relied principally on the binding authorities, including Church’s Estate, Hallock, and Spiegel’s Estate. The court also noted that the IRS and Treasury drew on Sec. 2036’s legislative history to devise the regulation, observing that Congress amended the statute to include interests retained for a term of years. In addition, the court noted that the IRS persuasively set out several of the administrative benefits of Regs. Sec. 20.2036-1(c)(2)(i), including consistency with trust accounting regulations under Sec. 662. The court also found that the fact that Sec. 2036 did not equate “income” with a fixed-term annuity in Sec. 2036 did not mean that the IRS and Treasury’s interpretation of Sec. 2036 was arbitrary or capricious. Thus, the court determined that the regulation was valid.

Estate tax return review

In Estate of Sower,²³ the Tax Court held that the IRS may examine the estate tax return of a husband who predeceased his wife, to determine whether the wife’s estate correctly applied the DSUE amount. Further, the court held that the IRS’s acceptance of the husband’s estate tax return (1) was not a closing agreement under Sec. 7121 and (2) did not mean the IRS was precluded from examining that return as part of its examination of the wife’s estate tax return.

When Frank Sower died in February 2012, his taxable estate was less than the basic exclusion amount allowed under Sec. 2010(c)(3). Frank’s estate filed an estate tax return and elected portability under Sec. 2010(c), allowing his surviving spouse, Minnie Sower, to use his DSUE amount (i.e., the difference between his taxable estate and the basic exclusion amount, approximately $1.26 million). When Minnie died in August 2013, her estate sought to use the DSUE amount. In examining Minnie’s estate tax return, the IRS reviewed Frank’s estate tax return and reduced the DSUE amount by the amount of taxable gifts that Frank had made during his life. As a result, the IRS determined a deficiency in Minnie’s estate.

In their lifetimes, each of the spouses had given approximately $1 million in taxable gifts, all between 2003 and 2005. Frank’s estate tax return had reported zero in taxable gifts but included approximately $945,000 in taxable gifts on a calculation worksheet. In November 2013, the IRS issued Frank’s estate an initial Letter 627, Estate Tax Closing Document, stating that the return had been accepted as filed. In July 2015, after adjusting the DSUE amount from approximately $1.26 million to $282,690, the IRS sent a second estate tax closing document to the executors of his estate. Similar to Frank’s estate tax return, Minnie’s estate tax return did not provide information on her lifetime taxable gifts. As a result of the DSUE amount decrease and an adjustment to Minnie’s taxable estate based on her lifetime taxable gifts, the IRS increased Minnie’s estate’s tax liability by approximately $788,000. Minnie’s estate timely petitioned the Tax Court, arguing:

1. The initial estate tax closing document that the IRS sent to Frank’s estate should be treated as a closing agreement under Sec. 7121.
2. Collateral estoppel prevented the IRS from reopening Frank’s estate.
3. The IRS’s examination of Frank’s estate, in conjunction with its earlier tax closing document issued to the estate, constituted an improper second examination.
4. Both the effective date of Sec. 2010(c)(5)(B) and the regulations precluded the IRS from adjusting the DSUE amount for gifts made prior to 2010.
5. Sec. 2010(c)(5)(B), as the IRS applied it here, runs contrary to congressional intent to allow portability and violates due process by overriding the statute of limitation on assessment.

Sec. 2010(c)(5)(B) permits the IRS to examine the estate tax return of the first-to-die spouse at any time to determine whether the DSUE amount claimed by the second-to-die spouse is correct. Temporary regulations under Sec. 2010 that were in effect when Frank and Minnie died reiterated the IRS’s authority to examine the return of the first-to-die spouse to determine whether the claimed DSUE amount is correct. Sec. 7602 permits the IRS to examine a variety of materials in “ascertaining the correctness of any return.”

Regarding Minnie’s estate’s first argument, the Tax Court rejected the assertion that the initial estate tax closing document provided to Frank’s estate was akin to a closing agreement under Sec. 7121, because there was no evidence of an agreement between Frank’s estate and the IRS.

Regarding Minnie’s estate’s second argument, the Tax Court noted that to succeed in arguing estoppel, a taxpayer (in this case, Minnie’s estate) must show (1) a false representation or wrongful misleading silence; (2) an erroneous statement of fact (as opposed to an opinion or statement of law); (3) ­ignorance of the true facts by the person claiming estoppel; and (4) that he or she was adversely affected by the acts or statement of the entity against whom ­estoppel is claimed. The court determined that the estate had established none of these elements.

Regarding Minnie’s estate’s third argument, the Tax Court rejected the estate’s reliance on Woodworth v. Kales²⁴ in arguing that reviewing Frank’s estate amounted to an impermissible second examination of the return, pointing out that in Burnet v. Porter,²⁵ the Supreme Court held the IRS could reopen a case after initial examination and that the Tax Court explicitly adopted that position in Estate of Meyer.²⁶ Further, the court noted that it has held that the IRS does not conduct a second examination when it does not obtain any new information, and because the IRS did not request any new information from Frank’s estate, there was no second examination. Finally, the court noted that the prohibition on second examinations protects only the party that was the subject of the first examination. Here, Frank’s estate, not Minnie’s estate, was the subject of the first examination.

Regarding Minnie’s estate’s fourth argument, the Tax Court rejected the estate’s assertion that because the gifts at issue were made before Sec. 2010(c)(5)(B) went into effect, the IRS could not adjust the DSUE amount by those gifts. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,²⁷ which created Sec. 2010(c)(5)(B), also made amendments to Sec. 2505, a gift tax provision that was not relevant in the case of Minnie’s estate. With regard to the effective dates for these amendments, Section 303 of the Act provided that “amendments made by this section shall apply to estates of decedents dying and gifts made after December 31, 2010.”

Although the estate interpreted this provision as meaning that the IRS could not adjust the DSUE on the basis of the gifts given before Dec. 31, 2010, the court concluded that it was clear that the effective date of Sec. 2010(c)(5)(B) was for decedents dying after Dec. 31, 2010. Because both Frank and Minnie died after Dec. 31, 2010, Sec. 2010(c)(5)(B) applied to both of their estates.

Regarding Minnie’s estate’s final argument, the Tax Court rejected its contention that the IRS’s application of Sec. 2010(c)(5)(B) runs contrary to congressional intent regarding portability and violates due process by overriding the statute of limitation on assessment. The court explained that it has held that the most persuasive evidence of congressional intent is the statutory text, and, based on the text of Sec. 2010(c)(5)(B), Congress expressly gave the IRS authority to examine returns of predeceased spouses and adjust the DSUE amount, whether or not the limitation period on assessment (Sec. 6501) had expired. Further, the court found that there was no violation of due process with respect to the statute of limitation because Sec. 2010(c)(5)(B) does not authorize the IRS to assess tax against the estate of the first-to-die spouse beyond the limitation period.

This case was one of first impression interpreting the ability of the IRS to ­examine a predeceased spouse’s return for the sole purpose of determining if the predeceased spouse’s estate correctly determined the DSUE amount — regardless of whether the statute of limitation for assessment of tax has run with regard to the return of the predeceased spouse’s estate. It is clear in the statute and the regulations that the IRS has this authority. It does not, however, permit the IRS to assess tax against the predeceased spouse’s estate if the statute of limitation for assessment of tax has run for that assessment. Here, the redetermination of the DSUE amount had implications for Minnie’s estate.

Because of portability, many estates are filing returns when they are not otherwise required to file a return, for the purpose of electing portability. In addition, for a return filed solely to elect portability, the regulations lessen the stringent requirements otherwise applicable to determining the value of some of the estate’s assets. Due to the low probability that these estates would be assessed additional tax if they were audited and stretched examination resources, the IRS is less likely to examine these returns. The IRS is more likely to examine them when the surviving spouse’s estate claims a DSUE amount that reduces its estate tax. Congress contemplated this likelihood in drafting the statute (no doubt with the assistance of Treasury).  

Footnotes

¹Sec. 1(j)(1)(E).

²Sec. 67(g).

³Sec. 164(b)(6).

⁴Joint Explanatory Statement of the Committee of Conference (available at docs.house.gov, at 40, incorporated into Conference Report to Accompany H.R. 1, H.R. Conf. Rep’t No. 115-466, 115th Cong., 1st Sess. (Dec. 15, 2017).

⁵Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.

⁶American Taxpayer Relief Act of 2012, P.L. 112-240.

⁷Wemyss, 324 U.S. 303 (1945).

⁸Merrill v. Fahs, 324 U.S. 308 (1945).

⁹Fiscalini, T.C. Memo. 2017-163.

¹⁰Tokarski, 87 T.C. 74, 77 (1986).

¹¹The $400 discrepancy between this figure in the slip opinion and the difference between the amounts given for adjusted basis and amount realized, $372,985, was unexplained.

¹²Also reflecting the same discrepancy from a calculated result of $122,985.

¹³T.D. 9593 and REG-141832-11, respectively.

¹⁴T.D. 9725.

¹⁵Estate of Sommers, 149 T.C. No. 8 (2017).

¹⁶Estate of Sommers, T.C. Memo 2013-8.

¹⁷Badgley, No. 4:17-cv-00877 (N.D. Cal. 5/17/18).

¹⁸Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).

¹⁹Helvering v. Hallock, 309 U.S. 106 (1940).

²⁰Church’s Estate, 335 U.S. 632 (1949).

²¹Spiegel’s Estate, 335 U.S. 701 (1949).

²²McNichol’s Estate, 265 F.2d 667 (3d Cir. 1959).

²³Estate of Sower, 149 T.C. No. 11 (2017).

²⁴Woodworth v. Kales, 26 F.2d 178 (6th Cir. 1928).

²⁵Burnet v. Porter, 283 U.S. 230 (1931).

²⁶Estate of Meyer, 58 T.C. 69 (1972).

²⁷Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.