Recent developments in estate planning: Part 2

This is the second part of a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and fiduciary income tax between June 2018 and June 2019. Part 1 (in the October 2019 issue) discussed trusts, GST tax, and inflation adjustments for 2019. Part 2 discusses gift and estate tax issues.

Gift tax

Valuation of S corporation

In Kress,¹ a district court generally relied on the taxpayers’ expert in determining the fair market value (FMV) of shares of a family-owned S corporation for gift tax purposes. It further concluded that, while Sec. 2703 applied to the valuation, it did not affect the valuation of the stock in a meaningful way.

The taxpayers were shareholders in a family-owned S corporation that was a vertically integrated manufacturer of corrugated packaging, folding cartons, coated labels, and related products. The S corporation bylaws required family shareholders to gift, bequeath, or sell the shares only to other family members.

In 2006 through 2008, the taxpayers gifted shares to their children and grandchildren. The IRS challenged the value of the gifts reported by the taxpayers on their gift tax returns. The taxpayers paid the deficiency and accrued interest, filed amended returns, and sought a refund. The issue before the district court was the FMV of the transferred shares.

The district court considered the experts of both the taxpayers and the IRS and determined one of the taxpayers’ experts to have used the soundest methodology, producing credible valuations, and, thus, accepted that expert’s analysis. The court next looked to whether Sec. 2703 applied, because of the restriction on the transfer of the stock. Sec. 2703(b) allows valuation adjustments for certain restrictions that are: (1) a bona fide business arrangement; (2) not a device to transfer the property to a decedent’s family members for less than full and adequate consideration; and (3) comparable to similar arrangements in arm’s-length transactions.

Regarding the first requirement, the district court took notice that courts have recognized that maintaining family ownership and control of a business may be a bona fide business purpose. The court determined that the S corporation was an operating business and that the bylaws were adopted to ensure that the family retained control of the company, to minimize the risk of disruption by a dissident shareholder, to ensure confidentiality of the S corporation’s affairs, and to ensure that all sales of the S corporation’s minority stock were to qualified Subchapter S shareholders. The court determined that, although the family transfer restrictions might not have maximized shareholder value, they were consistent with maintaining a ­family business and ensuring that the business continued to allow family members to make a living, while serving the interests of its employees and the community. Therefore, the court found that the first requirement was satisfied.

Regarding the second requirement, although by referring to a “decedent” the statute specifically applies to transfers at death, the IRS argued that it also applies to gifts during life, based on regulations that state that Sec. 2703(b)(2) applies to inter vivos transfers in addition to transfers at death.² However, the court noted that Congress has attempted to amend Sec. 2703(b)(2) to conform to this regulation and has failed to do so. Thus, the court determined that the statute is unambiguous in its reference to a decedent and that the second requirement does not apply to inter vivos transfers.

Regarding the third requirement, Regs. Sec. 25.2703-1(b)(4)(i) provides that a right or restriction is comparable to similar arrangements in an arm’s-length transaction if it could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arm’s length. Although the taxpayers argued that such restrictions are common in practice, the taxpayers provided no evidence of this. Therefore, the third requirement was not satisfied, and the court determined that it was improper for the taxpayers’ appraiser to consider the restriction in valuing the stock.

Although the district court found some of the adjustments in the taxpayers’ appraisal were improper under Sec. 2703(a), the court still found it was more persuasive than the IRS’s appraisal. The court noted that the taxpayers’ appraiser’s projections were more accurate and addressed the economic recession occurring at the time the transfers were made. Additionally, the taxpayers’ appraiser’s analysis was made without the benefit of hindsight. Thus, the court concluded that the taxpayers’ valuation should be used, with only a slight increase to remove the adjustments based on the taxpayers’ not satisfying Sec. 2703(b).

Completed gift

In Letter Ruling 201825003 the IRS determined that a transfer of legal title, naked ownership, and the remainder interest in artwork was a completed gift for gift tax purposes.

The taxpayer was predeceased by her spouse. Prior to the spouse’s death, the couple entered into a deed of transfer with two museums in a country outside the United States, in which they agreed to donate artwork that they owned on the death of the second to die of the spouses. The deed provided that the taxpayers (or, as was subsequently the case, a surviving spouse as taxpayer) would provide to the museums the legal title, naked ownership, and remainder interest in and to the artwork. The deed further provided that the taxpayer reserved for her benefit a life interest and usufruct in and to the art that were to automatically expire on her death. The taxpayer was restricted from disposing of the art and was barred from changing the disposition of the art to the museums. The deed contained a provision that if the taxpayer did not receive a favorable ruling regarding the U.S. federal gift tax treatment of the transfer, the deed would not come into force. The taxpayer requested a ruling that the transfer under the deed’s terms would not be treated as a completed inter vivos gift upon receipt of a ­favorable ruling.

The deed also contained some conditions subsequent in which the taxpayer would have the option to revoke the transfer of artwork, including: (1) the museums must comply with the requirements regarding the housing, display, and exhibition of the art, as set forth by the deed of trust (applicable to art delivered to the museums prior to the taxpayer’s death pursuant to the deed); (2) certain laws in the museums’ jurisdiction must not change; (3) the museums must not become privately owned; and (4) the tax laws of the foreign country in which the museums were located could not cause the taxpayer to become subject to taxation during the taxpayer’s life or upon death in connection with the transfer of art.

Regs. Sec. 25.2511-2(b) provides that a gift is complete when the donor has parted with the property’s dominion and control, retaining no power to change its disposition, whether for the donor’s or another’s benefit. Events beyond the donor’s control do not amount to dominion and control over the property and will not cause the transfer to be incomplete.

The IRS determined that powers that would cause revocation of the transfer did not depend on any act by the taxpayer. Therefore, the IRS ruled that such a transfer, but for the condition precedent of receipt of a favorable ruling on the gift tax treatment, would be a completed gift for gift tax purposes because the taxpayer had abandoned sufficient dominion and control over the property under the deed.

Determining whether retained powers are considered “sufficient dominion and control” for gift tax purposes as to cause an attempted gift to be incomplete is a facts-and-circumstances determination. This case, however, highlights that a transfer of a partial interest in property should be a completed gift for gift tax purposes if a taxpayer gives up dominion and control over that partial interest. Note, however, that just because the transfer is a completed gift for gift tax purposes does not mean that it might not still be includible in a decedent’s estate under Secs. 2035 through 2039 (the so-called string provisions), as the retention of such rights is not necessarily focused upon the standard of releasing dominion and control. Instead, these provisions focus on retained rights.

Estate tax

Clawback

On Nov. 23, 2018, Treasury and the IRS issued proposed regulations³ addressing the effect of recent legislative changes on the basic exclusion amount (BEA) used in computing federal estate and gift taxes. These regulations will affect donors of gifts made after 2017 and estates of decedents who died or will die after 2017.

Before the law known as the Tax Cuts and Jobs Act (TCJA)⁴ became effective on Jan. 1, 2018, the BEA under Sec. 2010(c)(3) was $5 million, indexed for inflation after 2011. The TCJA doubled the BEA to $10 million (also indexed for inflation) for estates of decedents dying from Jan. 1, 2018, through Dec. 31, 2025; then the BEA reverts to $5 million, effective Jan. 1, 2026.

The proposed regulations address this temporary change in the BEA. As noted in the preamble to the proposed regulations, the TCJA also directed Treasury to prescribe regulations necessary or appropriate to carry out Sec. 2001 with respect to any difference between the BEA applicable at the time of the decedent’s death and the BEA applicable with respect to any gifts made by the decedent.

The preamble to the regulations sets out four examples illustrating issues that could arise as a result of the temporary increase in the BEA and concludes that only the fourth situation could be problematic.

Situation 1. Whether for gift tax purposes, the temporarily increased BEA is reduced by pre–2018 gifts on which gift tax was paid: For donors who made both pre-2018 gifts that exceeded the $5 million BEA, incurring gift tax liability, and other gifts during the increased BEA period, does the gift tax computation apply the increased BEA ($10 million) to the pre-2018 gifts? If so, the concern is that the BEA otherwise available to shelter gifts made during the increased BEA period would be reduced and that the credit would effectively be allocated to a gift on which gift tax had already been paid.

The preamble points out that, in the gift tax determination, the tentative tax on all gifts from prior periods must be subtracted from the tentative tax on the donor’s cumulative gifts, including the pre-2018 gifts on which gift tax was paid. In this way, the full amount of the gift tax liability on the pre-2018 gifts is removed from the current-year gift tax computation, regardless of whether that liability was sheltered from gift tax by the BEA and/or was satisfied by a gift tax payment.

Further, the preamble notes, the BEA for the current year must also be reduced by the BEA allowable in prior periods against the gifts that were made by the donor in those prior periods. The increased BEA was not available before 2018 and was thus not allowable when the gifts were made. Because the increased BEA is reduced only by the amount of BEA allowable against prior-period gifts, the $10 million BEA is not reduced by a prior gift on which gift tax was paid.

Situation 2. Whether for estate tax purposes, the temporarily increased BEA is reduced by pre–2018 gifts on which gift tax was paid: For donors who made pre-2018 gifts that exceeded the $5 million BEA, incurring gift tax liability, and die during the increased BEA period, does the estate tax computation apply the increased ($10 million) BEA to the pre-2018 gifts? If so, the BEA otherwise available against the estate tax during the increased BEA period would be reduced, and the credit would effectively be allocated to a gift on which gift tax was paid.

The preamble notes that, under the estate tax determination, the hypothetical gift tax on the decedent’s post-1976 taxable gifts, including the pre-2018 gifts, must be subtracted from the tentative tax on the sum of the taxable estate and adjusted taxable gifts. As a result, the full amount of the gift tax liability on the pre-2018 gifts is removed from the estate tax computation. Next, the estate tax determination requires a credit on the amount of BEA for the year of death to be subtracted from the net tentative estate tax.

The regulations explain that the only time that the increased BEA enters into the computation of the estate tax is when the credit on the amount of BEA allowable in the year of the decedent’s death is netted against the tentative estate tax, which in turn already has been reduced by the hypothetical gift tax on the full amount of all post-1976 taxable gifts (whether or not gift tax was paid). Thus, the increased BEA is not reduced by the portion of any prior gift on which gift tax was paid, and the full amount of the increased BEA is available to compute the credit against the estate tax.

Situation 3. Whether the gift tax on a gift made after the increased BEA period (on Jan. 1, 2026, or later) is inflated by a theoretical gift tax on a gift made during the increased BEA period that was sheltered from gift tax when the gift was made: For donors who make gifts during the increased BEA period that are sheltered from gift tax by the $10 million BEA, as well as post-2025 gifts, does the gift tax determination on the post-2025 gift treat the gifts made during the increased BEA period as gifts not sheltered from gift tax by the credit on the BEA?

The preamble notes that, as in Situation 1, the tentative tax on gifts from prior periods must be subtracted from the tentative tax on the donor’s cumulative gifts. As a result, the full amount of the gift tax liability on the gifts from the increased BEA period is removed from the computation, regardless of whether that liability was sheltered from gift tax by the BEA or was satisfied by a gift tax payment. The credit based on the BEA for the current year must be reduced by the corresponding credits allowable in prior periods. Even if the sum of these credits exceeds the credit based on the BEA in the current (post-2025) year, the tax on the current gift cannot exceed the tentative tax on that gift and thus will not be improperly inflated. The gift tax calculation anticipates and avoids this situation, but no credit will be available against the tentative tax on the post-2025 gift.

Situation 4. Whether, for estate tax purposes, a gift made during the increased BEA period that was sheltered from gift tax by the $10 million BEA inflates a post–2025 estate tax liability: For donors in this situation who die after 2025, does the estate tax computation treat the gifts made during the increased BEA period as post-1976 taxable gifts not sheltered from gift tax by the credit on the BEA, considering that the post-2025 estate tax computation is based on the BEA in effect on the date of death rather than on the date the gift was made? In Situation 4, the preamble notes that the statutory requirements for the computation of the estate tax, in effect, retroactively eliminate the benefit of the increased BEA that was available for gifts made during the increased BEA period.

Accordingly, the proposed regulations would amend Regs. Sec. 20.2010-1 to: (1) provide that, for decedents dying or gifts made from Jan. 1, 2018, through Dec. 31, 2025, the increased BEA is $10 million; and (2) provide a special rule for when the portion of the credit as of the decedent’s date of death that is based on the BEA is less than the sum of the credit amounts attributable to the BEA allowable in computing gift tax payable within the meaning of Sec. 2001(b)(2). The special rule would base the portion of the credit against the net tentative estate tax attributable to the BEA upon the greater of the two credit amounts.

The problem resolved by the proposed regulations is the same that many practitioners feared with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)⁵ that increased the BEA from $1 million to $3.5 million, only to have EGTRRA sunset and return the BEA to $1 million. The estate tax calculation does not take into account changes in the BEA that may take place during the life of a taxpayer, while the calculation of gift tax does take such changes into consideration by effectively giving the taxpayer credit for the tax on prior taxable gifts, regardless of whether the tax was actually paid, due to fluctuations in the BEA. A change in the calculation is needed to ensure that taxpayers who take advantage of the fluctuating BEA during their lifetime are not subject to estate tax because the BEA at the time of the taxpayer’s death is lower than during the taxpayer’s life (and used by the taxpayer during his or her lifetime). While EGTRRA did not contemplate this mismatch, the TCJA did and directed Treasury and the IRS to draft regulations that would ensure the inequity did not occur.

The proposed regulations provide a simple solution to the differences in the way the gift and estate tax are determined by making the BEA the amount that is the greater of the BEA at the death of the taxpayer or the BEA used during the taxpayer’s lifetime. While this fix applies during the period of the TCJA, there is some question whether it will apply after the TCJA expires. The regulations should remain in effect after the TCJA sunsets, but there is always the chance that future congressional actions could change the result they produce.

Estate inclusion

In Estate of Cahill,⁶ the Tax Court denied partial summary judgment to an estate that contested a deficiency notice in which the IRS adjusted the value of the decedent’s rights in three split-dollar life insurance arrangements from $183,700 to more than $9.61 million. The court rejected the estate’s arguments that Secs. 2036, 2038, and 2703 did not apply to the arrangement.

This case will certainly make the use of split-dollar policies less attractive as a way to shift wealth from one generation to the next. A full discussion of the case and its implications will be the subject of an article in the December 2019 issue of The Tax Adviser.

Charitable deduction

In Dieringer,⁷ the Ninth Circuit upheld the decision of the Tax Court,⁸ finding that an estate tax deduction for the contribution of stock to a private foundation, which was based on a date-of-death valuation, was overstated. The court found that the value of the deduction was properly based on the value of the property transferred to the foundation, and numerous events had occurred between the date of the decedent’s death and the transfer of the property to the foundation that had reduced its value.

The decedent’s family owned a closely held corporation. The decedent was the vice president and chair of its board of directors. One of the decedent’s sons, Eugene Dieringer, was the president of the corporation and a board member. Before the decedent’s death, the only shareholders of the corporation were the decedent and her three sons. The decedent owned 425 of 525 voting shares and 7,736.5 of 9,220.5 nonvoting shares. Eugene Dieringer owned 100 voting shares, and Eugene Dieringer and one of his brothers each owned 742 nonvoting shares.

According to the decedent’s will, upon her death, all of her estate passed to her trust. The trust agreement provided for the decedent’s children to receive some personal effects but no other proceeds from her estate. The trust agreement also provided for $600,000 in donations to various charitable organizations. Any assets remaining in the trust would then pass to the family’s foundation.

Prior to the decedent’s death, the corporation’s board had preliminary discussions regarding the purchase of the decedent’s shares as part of ongoing succession planning. In anticipation of entering into a purchase agreement for the decedent’s shares, the corporation paid the trust $45,000 prior to the decedent’s death. When the decedent unexpectedly died on April 14, 2009, no specific redemption agreements were in place.

When the decedent died, Eugene Dieringer was appointed executor of the estate. To determine the value of the decedent’s shares in the corporation for estate purposes, the estate’s law firm requested an independent appraisal of the net asset value of the corporation. The appraisal determined that the value of the corporation as of the date of the decedent’s death was $17,777,626 and that the decedent’s shares were worth $14,182,471 ($1,824.19 per voting share and $1,732.97 per nonvoting share).

After the decedent’s death, the corporation’s board converted the corporation from C to S status to accomplish its long-term tax planning goals. As a result, the corporation’s board also decided to redeem the decedent’s shares that were to pass to the foundation. On Nov. 30, 2009, the corporation’s board entered into an agreement with the trust to redeem the decedent’s shares. At the direction of the corporation and after the conversion of the corporation from C to S, another appraisal of the decedent’s shares was performed for the purpose of the redemption. The redemption appraisal valued the decedent’s shares at $916 per voting share and $870 per nonvoting share (significantly lower than the original appraisal for the estate).

The appraiser testified that Eugene Dieringer instructed him to value the decedent’s shares as if they were a minority interest in the corporation and that he would not have done so without these instructions. The redemption appraisal, therefore, included a 15% discount for lack of control and a 35% discount for lack of marketability.

The corporation determined that it could not afford to redeem all of the decedent’s shares even at the new, lower valuation price. The redemption agreement was then amended, and consequently, the corporation redeemed all 425 voting shares and 5,600.5 nonvoting shares for a total purchase price of $5,263,462. After the redemption agreement was executed, the ownership of the corporation’s shares was as follows: (1) the trust owned 2,136 nonvoting shares; (2) Eugene Dieringer owned 200 voting shares and 2,932 nonvoting shares; and (3) two other sons owned the remaining voting and nonvoting shares.

In January 2011, the trust distributed the promissory notes obtained as a result of the redemption agreement and its remaining shares in the corporation to the foundation. The state probate court approved the redemption agreement and indicated that it would not constitute self-dealing under Sec. 4941. For its 2011 tax year, the foundation reported the following contributions: (1) a noncash contribution of the corporation’s shares with an FMV of $1,858,961; (2) a long-term note receivable with an FMV of $2,921,312; and (3) a short-term note receivable with an FMV of $2,250,000. The trust reported a capital loss of $385,934 for the sale of the 425 voting shares and a capital loss of $4,831,439 for the sale of the 5,600.5 nonvoting shares on its income tax return in the year of the distribution. The decedent’s estate filed its estate tax return, reporting no estate tax liability. The estate claimed an estate tax charitable contribution deduction of $18,812,181, based upon the date-of-death value of the decedent’s shares in the corporation (a significantly higher value than the foundation actually received).

The IRS issued a notice to the estate of a deficiency of $4,124,717 and imposed an accuracy-related penalty for error and negligence in using the date-of-death appraisal as the value of the charitable contribution of the decedent’s corporation shares. The estate filed a petition in the Tax Court challenging the deficiency notice. The IRS responded that post-death events should be considered in determining the value of the estate tax charitable contribution, as the actions by the decedent’s sons reduced the value of her contribution to the foundation.

The Tax Court upheld the IRS’s reduction of the estate’s charitable deduction and the deficiency assessment. The Tax Court found that the redemption was not part of the decedent’s estate plan, and there were valid business reasons for many of the transactions that took place after her death. The Tax Court also concluded, however, that post-death events — primarily the decision to apply a minority interest discount to the redemption value of the decedent’s shares — reduced the value of the contribution to the foundation and, therefore, reduced the value of the estate’s charitable deduction. The court also determined that the evidence did not support a conclusion that a poor business climate caused the reported decline in share values, as the estate argued. The estate appealed to the Ninth Circuit.

Sec. 2033 mandates that property in which the decedent had an interest be valued for estate purposes on the date of the decedent’s death. Except in some limited circumstances, such as when the executor elects to use an alternative valuation date under Sec. 2032, post-death events are generally not considered in determining the gross estate’s value for purposes of the estate tax. The Ninth Circuit pointed out, however, that charitable deductions are valued separately from the valuation of the gross estate. Separate valuations allow for the consideration of post-death events, as required by Ahmanson Foundation⁹and Code provisions. In Ahmanson, the decedent’s estate plan provided for voting shares in a corporation to be left to family members and nonvoting shares to be left to a charitable foundation. The Ninth Circuit in Ahmanson held that when valuing the charitable deduction for the nonvoting shares, a discount should be applied to account for the fact that the shares donated to charity had been stripped of their voting power. The court recognized that a decedent may be allowed an estate tax charitable deduction only for what the charity actually receives.

In the current case, the estate argued the charitable deduction must be valued as of the date of the decedent’s death, in keeping with the date-of-death valuation of an estate. The Ninth Circuit disagreed and noted that certain deductions not only permit consideration of post-death events but require them. For example, Sec. 2053(a) authorizes a deduction for funeral expenses and estate administration expenses — costs that cannot accrue until after the decedent’s death. Similarly, Sec. 2055(c) specifies that where death taxes are payable out of a charitable bequest, any charitable deduction is limited to the value remaining in the estate after such a post-death tax payment. Sec. 2055(d) prohibits the amount of a charitable deduction from exceeding the value of transferred property included in a gross estate — but, by negative implication, permits such a deduction to be lower than the value of donated assets at the moment of death.

The Third Circuit also recognized that valuations of the gross estate and a charitable deduction are separate and may differ. In In re Sage’s Estate,¹⁰ the Third Circuit held that “while a decedent’s gross estate is fixed as of the date of his death, deductions claimed in determining the net estate subject to tax may not be ascertainable or even accrue until the happening of events subsequent to death.”¹¹

Further, the Ninth Circuit held that its holding in Ahmanson compelled it to affirm the Tax Court’s ruling in ­Dieringer. In the latter case, the decedent structured her estate so as not to donate her shares in the corporation directly to a charity, or even directly to the foundation, but to the trust. The court found that the decedent enabled Eugene Dieringer to commit “almost unchecked abuse” of the estate by setting him up to be executor of the estate, trustee of the trust, and trustee of the foundation, in addition to his roles as president, director, and majority shareholder of the corporation. The court agreed with the Tax Court that Eugene Dieringer improperly directed the appraiser to determine the redemption value of the corporation’s shares by applying a minority interest valuation, when he knew a majority interest applied and the estate had claimed a charitable deduction based upon a majority interest valuation. Through his actions, Eugene Dieringer manipulated the charitable deduction so that the foundation received only a fraction of the charitable deduction claimed by the estate, the court stated.

The estate argued that Ahmanson applied only to situations where the testamentary plan diminishes the value of the charitable property. The Ninth Circuit rejected this argument and held that Ahmanson extended to situations where an estate would be able to produce an artificially low valuation by manipulation, as was the case before it. The court held that the Tax Court correctly considered the difference between the deduction and the property actually received by the charity due to Eugene Dieringer’s manipulation of the redemption appraisal value.

The estate also argued that any consideration of post-death events also required finding that the decline in value of the corporation stock was due, at least in part, to market forces. The Tax Court, however, had found that the evidence before it did not support a significant decline in the economy that resulted in a large decrease in value in only seven months. The Tax Court acknowledged that the adjusted net asset value of the stock decreased from $17,777,626 at the date of the decedent’s death to $16,159,167 at the date used for the ­redemption appraisal. Still, the Tax Court found that the decline in the value of the shares was primarily due to the specific instruction to value the decedent’s majority interest as a minority interest with a 50% discount.

The issue of looking at post-death events to determine the value of property included in a decedent’s gross estate has always been a contentious one, most notably regarding the valuing of claims against the estate for deduction purposes, causing a major overhaul of the regulations under Sec. 2053 in 2009. Here, the IRS was not going to allow the family to benefit from what it regarded as manipulation of the value. Given these facts, it would have been hard for the Ninth Circuit to reach a different conclusion.

Marital deduction

In Estate of Turner,¹² the Tax Court rejected the IRS’s assertion that an estate must reduce its marital deduction by amounts of federal estate and state death taxes attributed to the value of property transferred to a family limited partnership (FLP) approximately one year before the decedent’s death. Additionally, the court held that the estate could not increase its marital deduction by post-death income that was not included in the gross estate.

In April 2002, Clyde Turner and his wife, Jewell Turner, established an FLP to which each of them contributed approximately $4.33 million and received in exchange a 0.5% general partnership interest and a 49.5% limited partnership interest. By January 2003, Clyde Turner had transferred partnership interests totaling more than 21.7% as gifts to family members. Turner died testate in February 2004.

Two Tax Court decisions involving the estate preceded this one. In Estate of Turner I,¹³ the court held that the value of the property Turner had transferred to the FLP must be included in his gross estate under Sec. 2036(a). In Estate of Turner II,¹⁴ the court held that the estate was not entitled to a marital deduction for the value of the property that was included in the estate under Sec. 2036(a), because those assets would not actually pass to the surviving spouse.

Before the Tax Court issued its decision in Estate of Turner II, the IRS filed a computation for entry of decision calculating an estate tax deficiency of $362,822; after the decision, the IRS amended this calculation to $513,821, explaining that the first calculation had allowed a deduction for the interest on the estate tax but had not correspondingly reduced the marital deduction by the same amount. The estate objected, asserting two alternative computations, reflecting estate tax deficiencies of $144,136 or $341,073.

Following Estate of Turner II, the parties asked the court to determine how the marital deduction should be computed under Sec. 2056. To make this determination, the Tax Court needed to decide: (1) whether the estate had to reduce the marital deduction by the amounts of federal estate and state death tax attributable to the value of gifts made during the decedent’s lifetime but nonetheless included in the gross estate under Sec. 2036(a); and (2) whether the estate was entitled to increase the marital deduction by post-death income that was generated by estate assets, reported on the estate tax return, and paid to the surviving spouse.

Federal estate and state death taxes: The IRS asserted that the estate must reduce the marital deduction by the federal estate and state death taxes imposed on the estate because the only property available to pay the taxes was property that would otherwise pass to the surviving spouse and qualify for the marital deduction. The estate disagreed, asserting its right of recovery under Sec. 2207B, which generally allows an estate to recover from the property’s recipient an amount bearing the same ratio to the total estate tax paid as the property value bears to the taxable estate, provided any part of the gross estate on which tax has been paid includes the property value included in the estate by reason of Sec. 2036.

Sec. 2056(b)(4) requires that the value of any interest in property that qualifies for a marital deduction must take into account the effect of the federal estate tax or any estate, succession, legacy, or inheritance tax on the property’s net value. Although the executor must pay the estate tax under Sec. 2002, no Code section dictates which beneficiary’s interest bears the burden of the tax, and Turner’s will did not expressly address how the tax burden should be apportioned. Thus, the Tax Court looked to state law to determine an ­apportionment. The applicable state law was Georgia’s, which required federal estate and state death taxes to be paid from the estate’s residue.

Turner’s will expressed his intent to leave assets to his wife undiminished by any estate or death tax and having a value equal to the maximum marital deduction. Another provision established a trust for the benefit of the couple’s children and grandchildren if the decedent had any remaining unified credit. The estate asserted that this provision constituted the residuary clause of the will because it referred to the rest, residue, and remainder of property. The IRS asserted that no trust came into existence under that provision (because the decedent had no unified credit remaining at death) and, therefore, the only property available from which to pay the taxes was the property passing to the surviving spouse.

The Tax Court found that the parties’ arguments regarding which provision of the will constituted the residuary clause failed to focus on the important facts in this case. On the originally filed estate tax return, the estate reported that an 18.8525% FLP interest was allocated to Jewell Turner, and the remaining 8.9029% FLP interest was allocated to a credit bypass trust. The court noted, however, that, because it had held in Estate of Turner I that the value of the Sec. 2036 assets must be included in the value of the gross estate, the FLP allocations had changed. The court ­explained that:

• The Sec. 2036 inclusion exhausted the unified credit under Sec. 2010 and generated an estate tax liability;
• It was not necessary to fund a credit bypass trust because the unified credit had been fully used; and
• Both parties’ computations recognized that: (1) the trust would not be established; and (2) Jewell Turner was entitled to a distribution of the value of any property included in the estate, except for the Sec. 2036 assets (i.e., FLP interests) that her husband had transferred during life.

The Tax Court agreed with the estate. The court noted that Clyde Turner’s will clearly stated his intention not to reduce the marital deduction but was silent on how estate taxes should be paid or apportioned and how the right of recovery under Sec. 2207B should be determined.

The Tax Court rejected the IRS’s argument that the marital deduction could not be preserved because the Sec. 2207B right of recovery can be exercised only after taxes have been paid. The court stated that Sec. 2207B gives the executor a means to replenish the estate assets used to pay federal estate and state death tax liabilities attributable to the value of the Sec. 2036 assets that are included in the estate. With the value of the Sec. 2036 assets already included in the calculation of the gross estate, the court determined that any recovery under Sec. 2207B should not increase the gross estate but would enable the executor to distribute to the surviving spouse the net value of the estate, undiminished by the tax liabilities attributable to the Sec. 2036 inclusion.

Notably, the court was able to reach this conclusion because it found that the decedent’s estate plan did not include a waiver of the right of reimbursement under Sec. 2207B.Ultimately, the Tax Court held that the marital deduction need not be reduced here because (1) the tax liabilities were attributable to Sec. 2036 assets; (2) the estate had the right to recover the amount paid under Sec. 2207B; and (3) the estate was required to exercise its recovery right while satisfying the decedent’s intention that the surviving spouse receive her share undiminished by the estate’s tax obligations.

Post–death income: The estate ­asserted that the marital deduction should be increased by the amount of income generated by estate assets (post-death income) and allocated to the marital share. The IRS disagreed and argued that, because income from estate assets was not included in the gross estate, it did not constitute a deductible interest under Regs. Secs. 20.2056(a)-1(a) and (b), and it could not increase the marital deduction.

Agreeing with the IRS, the Tax Court found that Sec. 2056(a) determines the value of the taxable estate by deducting from the gross estate’s value an amount equal to the value of any interest in property passing from the decedent to the surviving spouse; a marital deduction is permitted only to the extent that the interest attributed to the surviving spouse is included in determining the value of the gross estate.

The estate based its contention on Regs. Sec. 20.2056(b)-4(d), which generally provides that the marital share includes income that is produced by property during the administration of the estate and payable to the surviving spouse. The IRS argued that the post-death income interest was not a deducible interest under the regulations because it was not included in the gross estate and that the estate misinterpreted the regulation.

The court concurred with the IRS’s position that the regulation defines “marital share” for the sole purpose of calculating the effect of administration expenses on the marital deduction. It does not increase the marital deduction otherwise allowable under Sec. 2056, nor could it, because Sec. 2056(a) limits the marital deduction to the value of the interest that is included in the value of the gross estate. Although post-death income may increase the marital share for purposes of calculating the effect that administration expenses have on the marital deduction, the court concluded that the regulations cannot increase the amount of the marital deduction under Sec. 2056.

If the IRS had been successful on the first issue addressed by the Tax Court, it would have resulted in an interrelated calculation that would have substantially increased the amount of the gross estate subject to estate tax. The decedent’s will contemplated that no estate tax would be due in the event that he died and had a surviving spouse. As is typical of estate planning for couples, the will established what is commonly referred to as a credit-shelter trust, in which the first-to-die spouse’s will utilizes the decedent’s remaining unified credit, and the rest is either given to the surviving spouse outright or to a marital trust. The portion of the first-to-die spouse’s estate going to the credit-shelter trust is shielded from estate tax to the extent of the decedent’s remaining unified credit, and the portion of the estate going to the marital trust is shielded from estate tax by the marital deduction.

In this case, the couple’s plan to avoid a taxable estate on the first-to-die spouse’s death did not quite work the way they intended. Because the assets in the FLP were includible in the decedent’s estate, the decedent had no remaining unified credit, and, thus, the credit-shelter trust was never created. Those assets were also not available to place in the marital trust because they had already been given to family members. Because the assets that would be used to pay the resulting estate tax could not pass to the marital trust, the IRS argued that these assets were subject to estate tax, resulting in a higher estate tax than just the estate tax due on the amount of the FLP assets brought into the estate under Sec. 2036.

The Tax Court correctly decided that, under Sec. 2207B, the estate had a claim against the parties holding assets that were includible in the decedent’s gross estate for the amount of estate tax the included assets generated. Thus, those parties were responsible for the estate tax, and the assets going to the marital trust would not be diminished by the tax.

Of course, the problem could have been averted if the decedent’s will had been clear about which assets would bear the payment of estate tax.

Valuation

In Estate of Streightoff,¹⁵ the Tax Court held that the decedent’s estate was not entitled to a lack-of-control discount for purposes of valuing a limited partnership (LP) interest held in the decedent’s revocable trust. Additionally, the court reduced the lack-of-marketability discount, in accordance with the valuation by the IRS’s expert, after determining that the decedent’s revocable trust held a full LP interest rather than an assignee interest.

Before the decedent’s death, his daughter, acting under a power of attorney, formed the LP and funded it with marketable securities, municipal bonds, mutual fund investments, and cash. The decedent, his children, and former daughter-in-law were the initial limited partners. The decedent held an 88.99% LP interest, and the remaining limited partners held interests ranging from 0.77% to 1.54%. The general partner, Streightoff Management LLC, held a 1% interest in the LP. The decedent’s daughter was the manager of the general partner. On the same date the partnership was created, the decedent (via his daughter) transferred his entire LP interest to his revocable living trust.

The partnership agreement provided that partners with a 75% interest could remove the general partner, and removal of the general partner would terminate the partnership. It further provided that persons who acquired an interest in the LP were “unadmitted assignees” entitled only to allocations and distributions in respect of their acquired interests until they were admitted as substitute partners. An unadmitted assignee could become a limited partner if three conditions were met: (1) the general partner consented; (2) the interest was acquired by a permitted transfer; and (3) the admitted partner agreed to be bound by the partnership agreement. The decedent’s revocable trust never became an admitted partner prior to the decedent’s death.

After the decedent’s death, on his estate tax return, his estate valued his LP interests by applying a combined 37.2% discount for lack of marketability, lack of control, and lack of liquidity to the net asset value of his 88.99% interest. The IRS challenged the estate’s valuation of the decedent’s LP interests, reducing the marketability discount and disallowing the discount for lack of control.

In Tax Court, the estate contended its discounted value was appropriate because the trust’s interest includible in the decedent’s estate was that of an assignee interest only, under the terms of the partnership agreement. The IRS countered that it was an LP interest and should be valued as such.

The Tax Court determined that the form of the agreement transferring the decedent’s interest to his revocable trust and the economic realities underlying the transfer supported a conclusion that the transferred interest was an LP interest. It further noted that in Kerr,¹⁶ as here, the only difference between the assignee interest and the LP interest was the right to vote, which the court determined was not a significant difference. In the case before it, the court noted that there were no votes by the limited partners after the transfer agreement had been executed. Thus, it concluded that the interest held by the revocable trust was to be valued for estate tax purposes as an LP interest.

Regarding the discount for lack of control, having found that the property interest to be valued for estate tax purposes was a limited interest, the Tax Court held that the decedent’s estate was not entitled to a discount for lack of control because the decedent’s 88.99% LP interest entitled him to considerable influence and control over the LP’s management. The interest gave him the power to remove the general partner, which, under the terms of the partnership agreement, effectively gave him the power to terminate the partnership. The court agreed with the IRS’s expert’s ­assessment that a prospective purchaser of the decedent’s interest would pay more for the degree of control embodied in it, such as the ability to unilaterally terminate the partnership if he or she did not agree with the management of the general partner.

Regarding the discount for lack of marketability, the Tax Court noted that to determine a discount for marketability, courts will examine: (1) the entity’s financial condition; (2) the entity’s capacity to pay and history of paying distributions; (3) the nature of the entity and its economic outlook; (4) the management of the entity; (5) the amount of control held by the interest; (6) restrictions on the transferability of the interest; (7) the required holding period for the interest; (8) the entity’s redemption policy; and (9) the costs associated with making a public offering. The court determined that the decedent’s LP interests were eligible for a discount for lack of marketability but agreed with the IRS that the estate’s discount was too large.

The court reasoned that, generally, no ready market exists for sales of interests in privately held entities, and a discount would be necessary to entice prospective buyers. However, the court agreed with the IRS’s expert’s discount of 18% (versus the estate’s 27.5% discount) because (1) the LP was capable of making distributions; (2) the LP’s overall financial condition and prospects were strong; (3) the LP’s investments were highly liquid (marketable securities and cash) and diversified, making an interest in the LP highly attractive to a hypothetical buyer; (4) the partnership agreement allowed for a right of first refusal; and (5) the LP interest that the decedent transferred to the revocable trust was a full partnership interest and not a mere assignee interest.

The assignee-versus-partnership-interest issue is another bad-facts case where the same parties stood on all sides of the formation of the LP and the transfer of the decedent’s LP interest to his revocable trust (i.e., the decedent’s daughter was the trust’s trustee, the estate’s executor, and the manager of the LP’s general partner). As the decedent’s attorney-in-fact, she also executed the transfer of the decedent’s LP agreement to the revocable trust and, as the manager of the general partner, could have admitted the revocable trust as a limited partner.

Regarding the discounts, the estate took an aggressive position, particularly by claiming a discount for lack of control where the decedent’s revocable trust owned 88.99% of the LP and substantial decisions could be made by partners holding 75% of the interests, in particular, to terminate the partnership. Also, the LP held very liquid assets, and a discount of 37.2% was sure to invite IRS scrutiny.  

Footnotes

¹Kress, No. 16-C-795 (E.D. Wis. 3/26/19).

²Regs. Sec. 25.2703-1(b)(1)(ii).

³REG-106706-18, 83 Fed. Reg. 59343.

⁴P.L. 115-97.

⁵Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

⁶Estate of Cahill, T.C. Memo. 2018-84.

⁷Dieringer, 917 F.3d 1135 (9th Cir. 2019).

⁸Dieringer, 146 T.C. 117 (2016).

⁹Ahmanson Foundation, 674 F.2d 761 (9th Cir. 1981).

¹⁰In re Sage’s Estate, 122 F.2d 480 (3d Cir. 1941).

¹¹Id. at 484.

¹²Estate of Turner, 151 T.C. No. 10 (2018).

¹³Estate of Turner, T.C. Memo. 2011-209.

¹⁴Estate of Turner, 138 T.C. 306 (2012).

¹⁵Estate of Streightoff, T.C. Memo. 2018-178.

¹⁶Kerr, 113 T.C. 449 (1999).