Recent developments in estate planning: Part 2

This article is the second installment of an annual update on recent developments in trust, estate, and gift taxation. The first installment appeared in the November issue, and the third installment will appear in the January 2023 issue. The update covers developments in estate and gift tax returns and planning during July 2021 through July 2022.

Estate tax — split-dollar life insurance arrangements

Cash-surrender values not includible in decedent’s estate

The Tax Court, in a fully reviewed opinion,¹ sustained an estate’s position that the cash-surrender values of certain life insurance policies were not includible in the estate. Specifically, the court held that (1) a decedent who had entered into split-dollar life insurance arrangements that required her revocable trust to pay the policies’ premiums possessed a receivable created by the arrangements; (2) Secs. 2036(a)(2) and 2038 did not require the policies’ cash-surrender values to be included in the gross estate because the decedent had no right to terminate the policies; and (3) Sec. 2703 applied only to property interests the decedent held when she died.

Marion Levine launched several highly successful businesses and amassed a fortune of approximately $25 million by the time she died. Levine’s business ventures began with a grocery store that she owned with her husband. After his death, she sold the grocery business and used the proceeds to branch into various real estate investments, stock portfolios, interests in Renaissance fairs and mobile home parks, and private lending. Her son, Robert, worked in the family business as an adult, but her daughter, Nancy, did not.

Planning for her older age, Levine gave her children statutory power of attorney in 1996 so they could manage her affairs if she became incapacitated. Because the relationship between her children was somewhat strained, Levine also gave a power of attorney to a family friend and business associate, Bob Larson.

Marion Levine, Larson, Robert Levine, and Nancy’s husband, Larry Saliterman, had formed 5005 Properties and 5005 Finance to manage the family’s real estate holdings and associated businesses. Larson, Robert, and Larry managed the day-to-day operations, and Marion Levine provided the funding. An accountant by training, Larson ultimately became president of both companies.

Levine began planning her estate in 1988, creating the Marion Levine Trust (a revocable trust), for which (1) she was the trustee; (2) Larson, Robert, and Nancy were successor trustees; and (3) Nancy, Robert, and their children were the beneficiaries. In 2005, Levine resigned as trustee and made Larson, Nancy, and Robert the sole co-trustees.

An estate planning firm worked with Levine between 1996 and 2007 to determine how best to handle her estate and pass it on to her children and grandchildren. The firm set up an intergenerational split-dollar life insurance arrangement under which she (via the Marion Levine Trust) would contribute money to a trust organized for the benefit of her children and grandchildren, and the trustees would use the contributed funds to purchase life insurance policies on her two children’s lives. In return, the trust promised to pay Levine the greater of (1) the money she advanced or (2) the policies’ cash value upon the earlier of the insureds’ deaths or the policies’ surrender. The right to repayment would be considered a receivable that the estate would have to report on the estate tax return. Levine ultimately loaned the trust $6.5 million to pay the life insurance premiums.

To orchestrate this set of transactions, the estate planning firm created the Marion Levine 2008 Irrevocable Trust (an insurance trust) to own the splitdollar life insurance policies; Levine’s children and grandchildren were the trust’s beneficiaries. Robert, Nancy, and Larson served as attorneys-in-fact, and the South Dakota Trust Co. LLC served as an independent trustee, with administrative obligations but no ability to choose investments for the trust. Larson was the sole member of the investment committee; South Dakota law defined certain fiduciary obligations the investment committee had to the insurance trust and its beneficiaries.

Larson approved the split-dollar life insurance arrangement on behalf of the insurance trust and was subject to a fiduciary duty to exercise his power to direct the insurance trust’s investments “prudently.” Because Robert had a preexisting health condition, the insurance trust decided to purchase two “last-todie” life insurance policies on Nancy and Larry rather than on Nancy and Robert. In summer 2008, Nancy, Richard, and Larson, as attorneys-in-fact for Levine, executed (1) paperwork on several loans to borrow the $6.5 million needed to make the premium payments, and (2) documents to put the split-dollar arrangement into effect. Levine died six months later, on Jan. 22, 2009.

Larson and Nancy, as attorneys-in-fact, signed gift tax returns for 2008 and 2009, reporting the gift’s value as the economic benefit transferred from the revocable trust to the insurance trust. Applying valuation rules in the regulations applicable to split-dollar life insurance arrangements,² Larson and Nancy placed the value at $2,644.

The estate reported the value of the split-dollar receivable owned by the revocable trust to be approximately $2 million. This represented the present value of the $6.5 million receivable based on the date of death of the last to die of Nancy and Larry — the date on which the receivable would be due.

The IRS objected to the small amount reflected on the gift tax return but ultimately resolved that issue before the matter went to trial. It also objected to the approximately $2 million receivable value, instead arguing that the cash-surrender values of the life insurance policies (approximately $6.2 million) should be included in the estate. The IRS reasoned that the insurance trust had the power to terminate the split-dollar arrangement at the time of Levine’s death. Therefore, the insurance trust and the beneficiaries of the revocable trust already effectively had access to $6.2 million. The IRS issued Levine’s estate a deficiency notice for more than $3 million, most of which was attributable to adjusting the value of Levine’s rights under the split-dollar arrangement.

The Tax Court summarized the key steps in the split-dollar arrangement as follows:

■ The insurance trust agreed to buy insurance policies on the lives of Nancy and Larry;

■ The revocable trust agreed to pay the policy premiums;

■ The insurance trust agreed to assign the insurance policies to the revocable trust as collateral; and

■ The insurance trust agreed to pay the revocable trust the greater of (1) the total premiums paid for these policies ($6.5 million); and (2) either (a) the current cash-surrender values of the policies upon the death of the last surviving insured or (b) the cash-surrender values of the policies on the date they were terminated, if they were terminated before both insureds died.

The Tax Court explained that split-dollar life insurance arrangements began as a means for employers to pay life insurance premiums for their employees, retain an interest in the policy’s cash value and death proceeds, and pass on to the employee or beneficiaries any remaining death benefit. Rev. Rul. 64-328 clarified that the death benefit portion of the policy would be included in the recipient’s income as an economic benefit. Estate planners wanted to help clients utilize the economic and tax benefits of life insurance, essentially using the policies as tax-advantaged savings. Final regulations from 2003³ govern all split-dollar arrangements entered into or materially modified after Sept. 17, 2003, and broadly define them as arrangements between an owner and nonowner of a life insurance contract in which:

1. Either party pays (directly or indirectly) all or part of the premiums;

2. The premium-paying party may recover all or part of the premium payments, and repayment is to be made from or secured by the insurance proceeds; and

3. The arrangement is not part of a group term life insurance plan (unless the plan provides permanent benefits).⁴

The Tax Court concluded that the split-dollar arrangement at issue met these requirements. Noting that the final regulations create two distinct regulatory regimes (the economic-benefit regime and the loan regime) to govern the income and gift tax consequences of split-dollar arrangements according to who owns the life insurance policy, the court concluded that the insurance trust owned the policies, and the loan-regime rules would apply. However, an exception to the general rule provides that the donor is treated as the owner of the contract if the only right or economic benefit the donee receives under a split-dollar life insurance arrangement is an interest in current life insurance protection. Noting that Sec. 2042 (regarding the inclusion of life insurance in the estate of a decedent) applies to life insurance policies only on a decedent’s own life, not split-dollar arrangements on the lives of others, the court found that neither Sec. 2042 nor its regulations were part of the requisite analysis in this case.

The IRS argued that the transaction at issue was a scheme to reduce Levine’s estate tax liability and, if it was a sale, was not a bona fide transaction because it lacked a legitimate business purpose. The estate should have reported the cash-surrender values of the policies rather than the value of the receivable, the IRS asserted, reasoning that:

■ Under Sec. 2036, Levine retained the right to income, or the right to designate who would possess the income, from the split-dollar arrangement;

■ Under Sec. 2038, she maintained the power to alter, amend, revoke, or terminate the enjoyment of aspects of the split-dollar arrangement; and

■ Even if the full values of the life insurance policies were not includible in Levine’s estate under Sec. 2036 or Sec. 2038, the restrictions in the split-dollar arrangement should be disregarded and the estate should include the policies’ full cash-surrender values in its taxable value under Sec. 2703.

Secs. 2036 and 2038: The Tax Court determined that life insurance policies could not constitute the “property” at issue in this case because the insurance trust had always been their owner. It further determined that the receivable also could not constitute the property, noting that the property was essentially retained, as opposed to transferred, because it had belonged to the revocable trust and now belonged to the estate. Ultimately, the court found that Levine made a voluntary inter vivos transfer within the meaning of Secs. 2036(a) and 2038 when she (via the revocable trust) transferred $6.5 million to the insurance trust.

The Tax Court further analyzed the transaction in light of its previous rulings in similar arrangements. The court determined that Levine’s transfer of $6.5 million gave her the right to the greater of a refund of the $6.5 million or the cash-surrender values of the policies after both Nancy and Larry died or the policies were canceled. Distinguishing these facts from those at issue in *Estate of Cahill⁵ and Estate of Morrissette (Morrissette II),⁶ the court stressed that, in the current case, the split-dollar arrangements between the revocable trust and the insurance trust provided that only the insurance trust had the right to terminate the split-dollar arrangement. In Cahill and Morrissette II, the donor, in conjunction with a second party, could mutually agree to terminate the arrangements. Absent a contractual right to terminate the life insurance policies, the court could not conclude that Levine had any possession or rights to their cash-surrender values.

The Tax Court rejected the IRS’s contention that Levine retained control under the principles of contract law even though only the insurance trust had the express power to terminate the deal and pay income to the estate because, the IRS argued, she could allow her estate to modify the terms of the arrangements. For the property at issue to be included in the estate under the broad language of Sec. 2036(a)(2), the court stated, the decedent’s power was required to be in the arrangement and not speculative under general principles of law. The court also rejected the IRS’s contention that Levine, through her attorneys-in-fact, stood on both sides of these transactions and, therefore, could unwind the split-dollar transactions. Because the insurance trust owned the life insurance policies and the trustee was the South Dakota Trust, which was directed by the investment committee with Larson as its only member, the court concluded that the only person on both sides of the transaction was Larson.

In considering each of Larson’s roles and how to apply Secs. 2036(a) and 2038, the Tax Court found that Larson could not surrender the life insurance policies in his capacity as attorney-in-fact and did not retain any right to possession or enjoyment of the transferred property. Additionally, the court rejected the IRS’s contention that Larson retained control because he could, in his capacity as the sole member of the investment committee, designate who would possess or enjoy the cash-surrender value of the properties by either surrendering them or terminating the agreement. The court indicated that the IRS’s position failed to consider Larson’s fiduciary obligations owed to the beneficiaries of the insurance trust.

Distinguishing the Levine facts from those in other cases in which the Tax Court took issue with fiduciary duties in the context of a family limited partnership (FLP) as being “illusory,” the court noted that Larson owed nonconflicting fiduciary duties both to the beneficiaries of the insurance trust and to Levine as an attorney-in-fact. In both Strangi⁷ and Powell,⁸ the fiduciary’s role as attorney-in- fact could have required him to act against his duties as trustee, the court explained. Finding it more likely than not that Larson’s fiduciary duties limited his ability to cancel the life insurance policies, the court concluded that the cash-surrender values of the life insurance policies should not be included in Levine’s estate under Sec. 2036(a)(2).

Sec. 2703: Finally, the Tax Court rejected the IRS’s assertion that the special valuation rules under Sec. 2703 applied to the split-dollar arrangement at issue. When Levine entered into the split-dollar arrangement, the IRS contended, she effectively restricted her right to control the $6.5 million and the insurance policies, but this restriction on her right to access the $6.5 million should be disregarded under Sec. 2703(a)(2). Levine’s estate argued that Sec. 2703 applied only to property Levine owned when she died, and the court agreed.

The key to the estate’s successful defense of not including the cash-surrender values of the life insurance policies at Levine’s death was that she did not have the power under the split-dollar arrangement, solely or in conjunction with others, to terminate the arrangement. Only the insurance trust had that power, and Levine was not a trustee of this trust. In Cahill and Morrissette, the decedent held the power in conjunction with others, triggering the application of Secs. 2036(a)(2) and 2038. In Morrissette, the estate ultimately prevailed because the Tax Court determined that the bona fide sale exception to Secs. 2036 and 2038 applied. Cahill involved a motion for summary judgment on the estate’s arguments that Secs. 2036, 2038, and 2703 did not apply to the split-dollar arrangement, which the Tax Court denied (therefore, further proceedings will determine whether the estate ultimately prevails). Levine provides an example of how to structure split-dollar arrangements to avoid Secs. 2036 and 2038 altogether — and not have to rely on the bona fide sale exception to avoid estate tax inclusion of the cash-surrender values.

The IRS had also raised the Sec. 2703 issue in Morrissette and Cahill. In Morrissette II, the Tax Court determined that the exception to the application of Sec. 2703 was met under the facts of the case and, therefore, Sec. 2703 did not apply. In Cahill, the Tax Court denied the estate’s motion for summary judgment on the issue. In Levine, the Tax Court determined that it was not an issue because she did not own the life insurance policies at her death (because she had not retained an interest in the policies via Sec. 2036 or 2038).

The Tax Court has questioned the strength of fiduciary duties in the context of family arrangements — distinguishing these arrangements from those at issue in the Supreme Court’s holding in Byrum,⁹ (respecting fiduciary duties that a majority owner of stock owes to its minority owners). This is especially true in the context of FLPs and the fiduciary duties that a general partner (usually held by senior family members) has to its limited partners (usually junior family members). In Levine, the court suggested that if the fiduciary’s duties were “nonconflicting” (i.e., where the duties held in one fiduciary capacity would not require the fiduciary to act against his or her duties as a fiduciary in another capacity), they are not “illusory” and should be respected. Although Levine did not involve an FLP, the opinion’s discussion of fiduciary duties from a Sec. 2036(a)(2) perspective may be a positive development for the evaluation of FLPs.

Gift tax

Transfer via spouse held an indirect gift to trust

In Smaldino,¹⁰ the Tax Court held that a gift to the taxpayer’s spouse was, in substance, an indirect gift to a trust for the benefit of the taxpayer’s heirs.

At the time of the trial, Louis P. Smaldino owned an $80 million real estate portfolio. He married Agustina Smaldino in 2006. Mrs. Smaldino had worked for her husband’s business since 1995. In 2012, Mr. Smaldino turned 69 and, after a health scare, decided to get his estate affairs in order. At the time, Mr. Smaldino had six children from a prior marriage and 10 grandchildren.

Mr. Smaldino owned and operated his real estate portfolio through limited liability companies (LLCs) held in a revocable trust. One of these entities, Smaldino Investments LLC, held 10 rental properties. In 2013, he transferred roughly 8% of the LLC’s class B member interests to a trust he had created a few months earlier for the benefit of his children and grandchildren. The value of these interests equaled his remaining gift tax exemption (approximately $1 million). Mr. Smaldino also transferred roughly 41% of the LLC’s class B member interests to Mrs. Smaldino, the value of which roughly equaled her remaining gift tax exemption (approximately $5.2 million). Mrs. Smaldino, in turn, transferred these interests to the trust the next day. In return for this accommodation, Mr. Smaldino promised Mrs. Smaldino that she would be given a larger share of assets from his revocable trust.

The Smaldinos each reported these gifts on their respective 2013 gift tax returns. The IRS determined that Mr. Smaldino had made a taxable gift to the trust of 49% of the LLC class B membership interests, which included the 41% interest he had given to Mrs. Smaldino, and issued Mr. Smaldino a notice of deficiency.

At trial, the IRS argued that, under the doctrine of substance over form, Mr. Smaldino’s alleged transfer of the LLC class B member interests to Mrs. Smaldino and her alleged retransfer of these same interests to the trust one day later were part of a prearranged plan among all parties involved to effectuate the transfer of the ownership of the LLC from Mr. Smaldino to the trust. Thus, the two purported transfers were an indirect gift from Mr. Smaldino to the trust. The IRS cited case law in which the courts used substance-over-form principles to recharacterize property transfers for related parties as indirect gifts.¹¹

Mr. Smaldino argued that those cases were not controlling, since none of them involved an interspousal transfer like the one currently before the Tax Court. He further argued that the transfer to his wife should be respected under Sec. 2523(a), which exempts interspousal transfers from gift tax.

The Tax Court, however, found that Sec. 2523(a) applies only in the situation where the donor transfers an interest in property to his or her spouse. The court concluded that Mr. Smaldino’s actions were ineffective to transfer membership interests in the LLC to Mrs. Smaldino. The court observed that Mr. Smaldino’s execution of a certificate of assignment of the LLC class B membership interests to Mrs. Smaldino, although a relevant factor to be considered in these circumstances, was not a controlling factor, particularly when the economic substance behind the execution of the certificate runs contrary to the content of the documents.

The Tax Court went on to analyze the LLC’s operating agreement, which it found distinguished between the assignment of economic rights in the LLC and the transfer of membership interests. In addition, the court found that Mr. Smaldino’s purported transfer of interests to Mrs. Smaldino was not among the types of transfers allowed under the LLC’s operating agreement. Under the agreement, the assignee of a membership interest could become a “substituted member” only if specific conditions were met, including the assignee’s execution of an instrument adopting the terms and provisions of the operating agreement. The court found that nothing in the record denoted that Mrs. Smaldino executed any instrument, nor would she have acquired more than an assignee’s interest in the LLC under the terms of the operating agreement.

The Tax Court also noted that the evidence did not indicate that Mr. Smaldino, as manager of the LLC and trustee of the revocable trust, ever gave express or implied consent for Mrs. Smaldino to be a member of the LLC pursuant to the operating agreement’s restrictions. The record, in fact, reflected that one day after purportedly transferring his LLC class B membership interests to his wife, Mr. Smaldino executed an amendment to the LLC’s operating agreement of which the LLC’s “sole member” was noted as the revocable trust. The court further found that a provision of the operating agreement that defined class A voting units and class B nonvoting units was never amended to show that Mrs. Smaldino held any of the LLC’s class B nonvoting units or any other member interest. The operating agreement, however, was amended to show that as of April 15, 2013, the trust held a 49% member interest in the LLC, which was made up of two blocks of LLC class B nonvoting units and to show Mr. Smaldino as having a 51% member interest in the LLC. Mr. Smaldino’s interest in the LLC was made up of two blocks consisting of class B nonvoting units and class A voting units.

The Tax Court also found it troubling that the amendment to the LLC’s operating agreement was undated, as opposed to the rest of the operating agreement amendments in the record. The certificates of assignment from Mr. Smaldino to Mrs. Smaldino were also undated, even though they purported to be effective April 14, 2013. The certificates of assignment from Mr. and Mrs. Smaldino to the LLC were also undated, despite purporting to be effective April 15, 2013. The court found it notable that the appraisal of the 49% LLC class B nonvoting member interest was dated Aug. 22, 2013, which was four months after the transfers supposedly took place.

Taking all the evidence into account, the Tax Court found it more likely than not that the undated certificates of assignment, in addition to the operating agreement amendment, were executed on Aug. 22, 2013, at the earliest. Practically, given the time gap between the effective dates of the purported transfers of the LLC class B membership to both Mrs. Smaldino and the trust, it was impossible for Mrs. Smaldino to exercise any ownership rights with respect to any LLC membership interests.

The Tax Court determined that Mr. Smaldino likely never intended for Mrs. Smaldino to exercise ownership rights in the LLC. Further, the court reasoned there was no economic significance for Mrs. Smaldino’s holding the interests in the LLC for one day before retransferring the interests to the ultimate donee that Mr. Smaldino had sought to receive them. Finally, the court determined that the LLC’s 2013 partnership return did not list Mrs. Smaldino as a partner at any time. Only Mr. Smaldino, with his 51% interest, and the trust, with a 49% interest, were included in that return. Thus, the court concluded that Mr. Smaldino never transferred any LLC membership interest to Mrs. Smaldino and, as a result, that the trust received the 49% class B membership interests as a gift from Mr. Smaldino.

While one might conclude that a transfer to a spouse for the spouse to make use of his or her gift tax exemption will not be respected if there is a subsequent transfer by the donee spouse of that property by gift, one should further consider two predominant reasons why the transfers were not respected in this case: (1) the parties did not respect the formalities required for the donee spouse to become a member of the LLC, and (2) there was no distancing between the two transfers such that there were real economic benefits to the donee spouse between the dates of the transfers.

Defined value clause locks in FLP percentages

In Nelson,¹² the Fifth Circuit affirmed a Tax Court decision¹³ holding that when a donor transferred partnership interests in an FLP, the transfer documents, and not subsequent events, controlled. Because the transfer agreements required an appraiser to determine the interests transferred within a fixed period, the court concluded that the donor transferred percentage interests determined by the appraiser and not “as finally determined for [gift] tax purposes.”

Mary P. Nelson and her husband, James C. Nelson, both residents of Texas, owned interests in an FLP, which had as its assets mainly shares of stock in a holding company for several family businesses. As part of their estate plan, Mrs. Nelson settled an intentionally defective grantor trust in 2008. In 2008 and 2009, Mrs. Nelson transferred her limited partner interests in the FLP to the trust in two separate transactions — a gift and then a sale. The gift and sale transfer instruments contained the following clauses regarding the amount of FLP interests to be transferred: The gift instrument provided, in pertinent part: “[Mrs. Nelson] desires to make a gift and to assign to [the trust] her right, title, and interest in a limited partner interest having a fair market value of [$2,096,000] as of December 31, 2008 … as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.”

The sale instrument provided, in pertinent part: “[Mrs. Nelson] desires to sell and assign to [the trust] her right, title, and interest in a limited partner interest having a fair market value of [$20 million] as of January 2, 2009 … as determined by a qualified appraiser within one hundred eighty (180) days of the effective date of this Assignment.”

Neither the gift nor the sale instruments contained a clause defining fair market value (FMV) or subjecting the FLP interests to reallocation after the valuation date. The Nelsons contracted with an accountant to appraise the value of the FLP interests. Based on the appraisals, Mrs. Nelson believed she gifted 6.14% and sold 58.65% of her interests in the FLP.

The Nelsons filed gift tax returns for 2008 and 2009. The 2008 gift tax returns reported as a split gift the transfer of the 6.14% interest in the FLP, corresponding to the values of the FLP interests as set forth in the appraisal. The couple did not report the sale on their 2009 gift tax returns. The IRS then audited the returns and issued notices of deficiency determining that, based on the percentage interests set forth in the gift instrument, the amount of the gift of the FLP interests on both spouses’ gift returns combined was $3,522,018, as opposed to $2,096,000, and in the sale instrument, the amount of the sale of the FLP interests was $33,607,038, as opposed to $20 million.

The Nelsons challenged the deficiencies in Tax Court. They argued that the initial valuation was correct and, even if it was not, that Mrs. Nelson had sought to transfer specific dollar amounts through a formula clause and that the amount of interests transferred should be reallocated should the valuation change. The Tax Court rejected these arguments, finding that the language in the transfer documents was not a valid formula clause that could support reallocation. Mrs. Nelson had transferred the percentage of interests that the appraiser had determined to have the values stated in the transfer documents; those percentages were fixed once the appraisal was completed. The Nelsons appealed to the Fifth Circuit.

The Fifth Circuit noted that the issue before it was whether the two transfer documents transferred specific percentages of limited partner interests or the amount of interests that equaled fixed dollar amounts. The latter theory would allow the percentage of interests transferred to be reallocated should the valuation change. The former would render the percentage of interests transferred fixed even in the face of a changed valuation.

Citing prior cases, the Fifth Circuit discussed that, when determining the amount of gift tax that applies to a transfer, the nature of that transfer is ascertained by looking to the transfer document and its language, rather than considering subsequent events. The court determined that the gift instrument expressly qualified the definition of “fair market value” for purposes of determining the interests transferred. The court stated: “By its plain meaning, the language of this gift document and the nearly identical sales document transfers those interests that the qualified appraiser determined to have the stated fair market value — no more and no less.” Because the taxpayers qualified it as the FMV that was determined by the appraiser, as opposed to a final determination based on gift tax principles, once the appraiser had determined the FMV of a 1% limited partner interest in the FLP and the stated dollar values were converted to percentages based on that appraisal, the court held, those percentages were locked and remained so even after the valuation changed.

The Fifth Circuit also discussed that the gift instrument lacked crucial language generally contained in transfer documents in formula-clause cases — specific language describing what should happen to any additional shares that were transferred should the valuation be successfully challenged. Nothing in the agreements compelled the trust to return excess units or do anything with excess units should the valuation change.

The Fifth Circuit found that the transfer agreements were not ambiguous — the meaning of the language prescribing that an appraiser would determine the percentage of interests to be transferred was definite and certain. The court stated: “The Nelsons’ reading, based on their subjective intent, would go beyond elucidating contractual language to changing and overriding it. Texas contract law does not allow for that.” Furthermore, even if the contracts were ambiguous, the court did not find objective facts or circumstances surrounding the transfer that would render a different result. The court noted that the only objective circumstance the taxpayers could point to in support of their reading was the setting of the transfer, as part of the estate planning that aimed to protect their assets while also avoiding as much tax liability as possible. However, the court determined that consideration of the estate plan context still hewed too closely to consideration of the taxpayers’ subjective intent to alter the understanding of the contractual language.

Notably, the Fifth Circuit emphasized that the language in the Nelsons’ gift instrument differed from similar contracts in the same setting. The court held that the fact that the transfers involved a family trust and family assets and were made in the setting of estate planning should not be used to interpret the taxpayers’ intent.

IRS challenge of fractional-interest discounts denied summary judgment

In Buck,¹⁴ a district court denied the government’s motion for partial summary judgment in its challenge of an individual’s valuations of timberland for gift tax purposes, finding that his gifts of fractional interests in the land to his sons must be valued separately at the time of transfer.

Between 2009 and 2013, the taxpayer purchased $82,853,050 in tracts of timberland in upstate Maine and Vermont. From 2010 to 2013, he gifted interests in these tracts to his two sons. Each son received a 48% interest in each tract, while the taxpayer retained a 4% interest. Each year from 2010 to 2013, the taxpayer reported and paid gift tax on those transfers as two separate gifts to his sons, each representing the gifted 48% interest in given tracts. The taxpayer discounted the value of the gifts for the possibility that each interest would be less valuable to a hypothetical buyer. The taxpayer thus declared the discounted value of each son’s 48% fractional interest to be $18,496,249, for a combined value of $36,992,498. This represented a 55% discount from the total purchase price.

The IRS challenged the taxpayer’s valuations and assessed gift tax deficiencies, which the taxpayer contested in the district court action. The IRS moved for partial summary judgment, asking the court to conclude as a matter of law that no discount should be available for a gift of a fractional interest unless the taxpayer held the interest in fractional form before the gift, rather than viewing several simultaneously gifted portions of the property as fractional interests in the hands of the donor for the purpose of valuing the gift.

The IRS advanced two principal arguments in support of its position. First, it argued that “allowing the discounts would endorse a circumvention of one of the primary purposes of the gift tax, which is to assure that estate tax is not avoided.” The district court agreed with the IRS that, if this were a case about estate tax, then no discounts would be allowed based on the separate values of the interests received by each son.

The IRS cited prior jurisprudence for the proposition that the gift tax and the estate tax are in pari materia and must be analyzed together.¹⁵ After reviewing these cases, the district court determined that the same words appearing in the gift tax statute and the estate tax statute should be understood to have the same meaning. They also supported the finding that a taxpayer should not also be required to pay gift tax where the value of property the taxpayer retains after making a gift will be included in the taxpayer’s gross estate for estate tax purposes. However, the court concluded that the cases do not support a legal conclusion that if there would be no discount in determining the value of property for purposes of the estate tax, the interests in the property should be aggregated and there should be no discount in determining the value of those interests for purposes of the gift tax.

Second, the IRS argued that “the value of a gift for federal gift tax purposes is the value to the donor, not the donee.” The IRS then argued that the value of the properties gifted here should reflect the economic reality to the taxpayer of the value of a 96% interest in each property that he transferred. Disallowing fractional discounts on a previously unified interest ensures that “the value of the gift made by the donor, not the measure of enrichment to the donee, … is determinative,” the IRS argued. Alternately phrased, even if the creation of fractional interests decreased the property’s value, it was worth more in the donor’s hands before the fractional interests were created, and gift tax should be calculated on the basis of that old value, not the new value.

The court noted it was required to analyze the value of gifts at the time they passed from donor to donee. Sec. 2512(a) provides: “If the gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift.” By way of contrast, Sec. 2031, pertaining to the valuation of bequests, expressly looks at the value of all property to the extent of the interest therein of the decedent at the time of the decedent’s death.

The court analyzed Shepherd,¹⁶ where the Tax Court applied fractional nterest discounts in similar circumstances. In that case, the taxpayer formed a partnership with his two sons, each of whom held a 25% interest, with the taxpayer holding 50%. The taxpayer transferred to the partnership shares of his majority interests in three banks, as well as an undivided 50% interest in leased land in which the taxpayer and his wife owned the entire interest, subject to the lease. The taxpayer claimed a minority discount of 15% for the bank shares and reported the value of the leased land as a whole at $400,000. The IRS assessed a gift tax deficiency on the basis that the FMV of the 50% interest in the leased land that petitioner gifted to his sons was $639,300, far greater than the $200,000 value that the taxpayer had claimed, but the IRS accepted the minority discount for the bank shares as reported.

The district court found that Shepherd was consistent with the well-established principle that gifts should be valued at the time of the gift, not before or after they are made. Shepherd also made clear that each separate gift must be valued separately.

In Buck, under applicable law, the gifts were not a single 96% interest but two 48% interests, with each given to one of two donees, and, thus, the gifts must be valued separately at the time of transfer, the district court held. The court denied the IRS’s motion for partial summary judgment with regard to whether the discounts were appropriate in valuing gifts of partial interests in the taxpayer’s properties for federal gift tax purposes.

Subsequent events considered in GRAT’s valuation

In a Chief Counsel Advice (CCA),¹⁷ the IRS Office of Chief Counsel concluded that a grantor retained annuity trust (GRAT) funded with aggressively undervalued shares of stock in a company failed to meet the requirements of Sec. 2702; therefore, the annuity interest retained by the taxpayer was valued at zero and was included in determining the value of the taxable gift of the remainder interest, resulting in a taxable gift of the entire value of the stock transferred into the GRAT, rather than a “zero gift.”

The taxpayer founded and owned all of the stock of a successful company. At the end of year 1, he reached out to a pair of investment advisers to research options for selling the company to a third-party buyer. Approximately seven months later, the investment advisers presented the taxpayer with five offers from various corporations. Three days after receiving the offers, the taxpayer transferred shares of his company to a two-year GRAT and retained an annuity stream for a two-year period. The annuity payments were based on a fixed percentage of the initial FMV of the property transferred to the GRAT. The company’s shares were valued based on an appraisal of the company on Dec. 31 of year 1, which was roughly seven months before the shares were transferred to the GRAT (the GRAT appraisal). The GRAT appraisal had been obtained to satisfy the reporting requirements for the company’s nonqualified deferred compensation plans under Sec. 409A. The GRAT appraisal was prepared before any discussions and/or offers to sell shares occurred and, therefore, did not reflect these facts.

Approximately three months after the taxpayer received the initial offers, four of the corporations submitted final offers. Several weeks after the final offers were received, the taxpayer transferred shares of the company to a charitable remainder trust (CRT) and retained an income interest. For purposes of valuing the shares transferred to the CRT, the taxpayer obtained a qualified appraisal,¹⁸ as required by Sec. 170(f)(11)(A), for purposes of receiving an income tax charitable deduction for the remainder interest transferred to charity (the CRT appraisal). The per-share value was equal to the tender offer the taxpayer ultimately accepted for the company.

The tender offer accepted by the tax-payer involved an initial cash payment for a portion of the outstanding shares of the company that was equal to roughly three times more than the value determined under the GRAT appraisal that was used to report the value of the shares transferred to the GRAT on the taxpayer’s gift tax return. Roughly six months following the end of the GRAT’s two-year term, the purchasing corporation purchased the remaining balance of the company’s shares at a price-per-share value that was nearly four times the value that was determined under the GRAT appraisal.

The IRS noted that the value of a gift for gift tax purposes is based on the willing-buyer, willing-seller test.¹⁹ It then summarized case law establishing that the willing buyer and willing seller are hypothetical persons and the meaning of the phrase “reasonable knowledge of relevant facts.”²⁰ Finally, it stated that the value of property for gift tax purposes generally does not take into consideration post-transfer events but that case law has allowed consideration of such post-transfer events that are relevant to the question of value.

The IRS then focused on Ferguson,²¹ an anticipatory assignment-of-income case, in which the Ninth Circuit, agreeing with the Tax Court, held that at the time the taxpayers made donations to certain charities, the merger in question was “practically certain” to be executed, given the targeted search by the taxpayers to find merger candidates, the generous terms of the merger, and the exclusive negotiations with one of the corporations immediately prior to the final agreement. In Ferguson, the tender offer started on Aug. 3, 1988. Twelve days later, the taxpayers donated some of their shares in the target company to certain charities. On Sept. 9, 1988, the charities tendered the donated stock. On Sept. 12, 1988, the final shares needed to execute the merger were tendered. On or about Oct. 14, 1988, the merger was completed. The IRS stated in the CCA that, although the Ferguson opinion deals entirely with the assignment-of-income doctrine, it also relies on the belief that the facts and circumstances concerning a transaction are relevant to determining whether a merger is likely to be executed.

The IRS determined that the facts of the CCA present an issue similar to Ferguson with respect to whether the FMV of the stock should take into consideration the odds of the merger as of the date of the transfer of the shares to the GRAT. It concluded that Ferguson, along with previously cited case law regarding the consideration of post-transfer events in determining value, applied and that the value determined in the Dec. 31, year 1, appraisal did not represent the FMV of the company shares as of the date of the transfer to the GRAT. Under the hypothetical willing-buyer and willing-seller test, as of the date of the transfer of the shares to the GRAT, a willing buyer and willing seller would be reasonably informed throughout the negotiations over the purchase and sale of the shares and would have knowledge of all pertinent facts, including the merger. Ignoring the facts and circumstances of the pending merger would undermine the FMV concept and lead to an unfounded valuation.

The IRS next focused on whether Sec. 2702 applied because the requirements of a GRAT set forth in Regs. Sec. 25.2702-3 had not been met. Sec. 2702 generally provides that, for purposes of determining whether a transfer in trust for the benefit of certain family members is a gift, the value of the interest in the trust retained by the donor or related party is zero unless it is a qualified interest. One such qualified retained interest is an annuity interest as set forth in Regs. Sec. 25.2702-3. The IRS cited the relevant requirements for a qualified retained annuity interest in a trust.

The IRS then cited Atkinson,²² where a donor created a charitable remainder annuity trust (CRAT), but no payments were actually made from the trust to the donor during the two-year time frame from when the trust was created to the donor’s death. The Tax Court agreed in that case with the IRS’s argument that the trust was not a valid CRAT under Sec. 664(d)(1) since the required annual annuity amount was never actually paid. The Tax Court added that, although the terms of the trust met the letter of the statute by providing for 5% annual distributions, the trust did not operate in accordance with those terms. Thus, the trust did not meet the requirements of the statute and could not qualify for treatment as a charitable remainder trust. The taxpayer argued before the Eleventh Circuit that the deduction was denied as a result of a “foot fault,” or minor error, but the appellate court disagreed and denied an estate tax charitable deduction for the remainder interest in the CRAT.

The IRS concluded in the CCA that, although the GRAT instrument appeared to have met the requirements of a qualified annuity interest in Regs. Sec. 25.2702-3, intentionally basing the fixed annuity amount required by Sec. 2702(b)(1) and Regs. Sec. 25.2702-3(b)(1)(i) on an undervalued appraisal led to a failure of the retained annuity interest to function exclusively as a qualified interest from the creation of the GRAT. Therefore, the trustee’s failure to comply with the requirement of a fixed annuity amount was deemed an “operational failure” since the trustee paid an amount that had no connection to the initial FMV of the property transferred to the GRAT. The amount was instead based on an outdated and confusing appraisal of the company, at a time when the taxpayer had received several multibillion-dollar offers to acquire it.

The CCA noted that the artificial annuity to be paid was less than 34 cents on the dollar instead of the required amount, which one can assume was the per-share price based on the tender offer accepted by the taxpayer for the company. This substantial undervaluation may be why the IRS held the GRAT to be invalid as disregarding one of the qualified retained annuity requirements in Regs. Sec. 25.2702-3. Regs. Sec. 25.2702-3(b)(2) provides:

“If the annuity is stated in terms of a fraction or percentage of the initial fair market value of the trust property, the governing instrument must contain provisions meeting the requirements of §1.664-2(a) (1)(iii) of this chapter (relating to adjustments for any incorrect determination of the fair market value of the property in the trust).”

Regs. Sec. 1.664-2(a)(1)(iii) provides, in relevant part:

“The stated dollar amount may be expressed as a fraction or a percentage of the initial net fair market value of the property irrevocably passing in trust as finally determined for Federal tax purposes. If the stated dollar amount is so expressed and such market value is incorrectly determined by the fiduciary, the requirement of this subparagraph will be satisfied if the governing instrument provides that in such event the trust shall pay to the recipient (in the case of an undervaluation) or be repaid by the recipient (in the case of an overvaluation) an amount equal to the difference between the amount which the trust should have paid the recipient if the correct value were used and the amount which the trust actually paid the recipient.”

While the CCA cites Regs. Sec. 25.2702-3(b)(2) for the requirements of a qualified annuity interest, the IRS failed to address the application of this requirement to the facts before it. One can assume that this provision was in the GRAT instrument, as the IRS states that the GRAT appeared to meet the requirements of Sec. 2702 and Regs. Sec. 2702-3.

The question for the IRS, then, is why did it ignore its own regulations, specifically, Regs. Sec. 25.2702-3(b)(2)? In Rauenhorst,²³ the IRS made an argument contrary to one of its published revenue rulings. The Tax Court held that the IRS could not do so unless it first revoked the ruling. That should be the case especially with regard to current Treasury regulations.

It also is questionable whether Ferguson should apply to valuation cases. Ferguson is an anticipatory assignment-of-income case; valuation was not at issue. The CCA had already cited other cases in which post-death events could be considered for purposes of the willing-buyer, willing-seller test, and it may have been reasonable to take into consideration for valuation purposes the likelihood that the company might be sold. However, that does not require that the valuation equal the price of the ultimate sale.

Regarding the application of Atkinson, nothing in the facts of the CCA indicated that the GRAT was not being administered pursuant to the terms of the GRAT instrument. There was no “operational failure” as there had been in Atkinson (i.e., the failure of the trustee to make the annual annuity payments). Valuation was the issue and should have been addressed by the IRS via Regs. Sec. 25.2702-3(b)(2).

If Regs. Sec. 25.2702-3(b)(2) had been followed in this case, the parties would have agreed upon a valuation of the shares on the date of transfer to the GRAT and the annuity payments would have been adjusted — resulting in more of the shares of the company and/or its income being paid to the taxpayer.

The IRS has audited a number of GRATs over the last few years, with the result as previously stated, if the property transferred to the GRAT was undervalued. However, the CCA shows the IRS’s willingness to invalidate a GRAT when the taxpayer uses an egregious valuation. This CCA serves as a warning to taxpayers about the need to get good appraisals for gift and estate tax purposes and to be mindful of this new argument, particularly where views regarding the valuation of an asset may differ significantly. It is questionable whether a court would agree with the IRS in this case, since the IRS did not address Regs. Sec. 25.2702-3(b)(2); however, as it stands, the IRS may use this reasoning in similar situations going forward.

As a rule of thumb, the rules for a qualified appraisal for income tax charitable deductions in Sec. 170(f)(11)(E) should be followed. The appraisal should be dated as of the date of the transfer or not more than 60 days prior to the date of transfer.

¹Estate of Levine, 158 T.C. No. 2 (2022).

² See Regs. Sec. 1.61-22(d)(2).

³ T.D. 9092.

⁴ Regs. Sec. 1.61-22(b)(1).

⁵ Estate of Cahill, T.C. Memo. 2018-84.

⁶ Estate of Morrissette, T.C. Memo. 2021-60.

⁷ Estate of Strangi, T.C. Memo. 2003-145.

⁸ Estate of Powell, 148 T.C. 392 (2017).

⁹ Byrum, 408 U.S. 125 (1972).

¹⁰ Smaldino, T.C. Memo. 2021-127.

¹¹ Heyen, 945 F.2d 359 (10th Cir. 1991); Estate of Bies, T.C. Memo. 2000-338; Estate of Cidulka, T.C. Memo. 1996-149.

¹² Nelson, 17 F.4th 556 (5th Cir. 2021).

¹³ Nelson, T.C. Memo. 2020-81.

¹⁴ Buck, 563 F. Supp. 3d 8 (D. Conn. 2021).

¹⁵ Merrill v. Fahs, 324 U.S. 308 (1945); Estate of Sanford, 308 U.S. 39 (1939); Converse, 163 F.2d 131 (2d Cir. 1947).

¹⁶ Shepherd, 115 T.C. 376 (2000).

¹⁷ CCA 202152018, released Dec. 20, 2021.

¹⁸ As defined in Sec. 170(f)(11)(E).

¹⁹ The price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. See Regs. Sec. 25.2512-1.

²⁰ Estate of McCord, 120 T.C. 358 (2003), rev’d on other grounds, 461 F.3d 614 (5th Cir. 2006); Estate of Newhouse, 94 T.C. 193 (1990); see also Estate of Kollsman, T.C. Memo. 2017-40, aff’d, 777 Fed. Appx. 870 (9th Cir. 2019).

²¹ Ferguson, 174 F.3d 997 (9th Cir. 1999), aff’g 108 T.C. 244 (1997).

²² Atkinson, 115 T.C. 26 (2000), aff’d, 309 F.3d 1290 (11th Cir. 2002).

²³ Rauenhorst, 119 T.C. 157 (2002).

Contributors

Justin Ransome, CPA, J.D., MBA, is a partner in the National Tax Department of Ernst & Young LLP in Washington, D.C. He would like to thank his colleagues in the firm’s National Tax Department in Private Tax for their contributions to this article, as well as Fran Schafer for her thoughtful comments on the article. The views expressed here are those of the author and do not necessarily reflect the views of Ernst & Young LLP. For more information about this article, contact thetaxadviser@aicpa.org.

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