Recent developments in estate planning: Part 1

Contributors: Members of the Ernst & Young LLP National Tax Department in Private Tax

This article is the first installment of an annual update on recent developments in trust, estate, and gift taxation. The second and third installments will appear in the December and January issues, respectively. In this first installment, the topics include estate tax closing letters, the basic exclusion amount, estate debts and expenses, and extending the time to elect portability. The period covered is from July 2021 through July 2022.

Estate tax closing letters

On Sept. 22, 2021, Treasury and the IRS issued final regulations¹ establishing a new $67 user fee for estates to receive an estate tax closing letter.

Prior to June 2015, the IRS generally issued an estate tax closing letter for every estate tax return filed. The IRS changed its practice for estates of decedents dying on or after June 1, 2015, and now offers an estate tax closing letter only upon the request of an authorized person. The reasons for this change were: (1) the volume of estate tax returns filing increased due to the enactment in December 2010 of the portability of a deceased spouse’s unused applicable exclusion amount for the benefit of the surviving spouse; and (2) the IRS recognized that an account transcript with a transaction code and explanation of “421 — Closed examination of tax return” is available as an alternative to an estate tax closing letter.

The final regulations adopting the $67 user fee do not establish a procedure for requesting an estate tax closing letter and paying the user fee. Instead, as the preamble to the regulations notes, the procedure for requesting, and paying the fee for, the estate closing letter is found on the Pay.gov website (see also FAQs available on IRS.gov).

While the proposed regulations had defined the person liable for the fee to include a person authorized under Sec. 6103 to receive an estate tax closing letter, the final regulations remove the reference to Sec. 6103, explaining that the section governs the disclosure of return information but does not necessarily govern who would be liable for the payment of the user fee.

Basic exclusion amount

On April 27, 2022, Treasury and the IRS issued proposed regulations² amending estate tax regulations on the basic exclusion amount (BEA) used in computing federal estate and gift taxes. The proposed regulations would affect estates of decedents dying after a reduction in the BEA (currently set to occur on Jan. 1, 2026) who made certain types of gifts before the BEA was reduced.

Background

The 2017 law known as the Tax Cuts and Jobs Act (TCJA)³ increased the BEA from $5 million, adjusted for inflation after 2011, to $10 million, also adjusted for inflation, for decedents dying, and gifts made, in calendar years 2018 through 2025. Under current law, the BEA will revert to $5 million, adjusted for inflation, on Jan. 1, 2026.

In addition to increasing the BEA,⁴ the TCJA added new Sec. 2001(g)(2), authorizing the Treasury secretary to issue regulations addressing the tax consequences for an estate whose decedent makes gifts between $5 million and $10 million during calendars years 2018 through 2025, when the BEA is $10 million, but dies after 2025, when the BEA decreases to $5 million.

In late 2019, the IRS and Treasury issued final regulations (T.D. 9884) under Sec. 2010 to address this situation. The final regulations adopted a special rule for the purpose of ensuring that the donor’s estate is not taxed on completed gifts on which no gift tax was imposed due to the increased BEA. The special rule allows the estate to compute its estate tax credit using the higher of: (1) the BEA applicable on the decedent’s date of death, or (2) the BEA applicable to gifts made during the decedent’s life (Sec. 2001(b)).

The preamble to T.D. 9884 noted that further consideration would be given to the issue of whether gifts that are not true inter vivos transfers but rather are includible in a decedent’s gross estate should be excepted from the special rule. The new proposed regulations address this question.

Rationale for the proposed exception

The preamble to the proposed regulations explains that the special rule currently does not distinguish between completed gifts that are treated as: (1) adjusted taxable gifts for estate tax purposes and not included in the donor’s gross estate; and (2) testamentary transfers for estate tax purposes and included in the donor’s gross estate. The Code, however, distinguishes between these two types of transfers.⁵ The proposed regulations generally would deny the benefit of the special rule to “includible gifts” by maintaining the Code’s distinction between completed gifts treated as adjusted taxable gifts and those treated as testamentary transfers. In either case, the Code ensures that the gift is treated consistently with respect to credits allowable in the year in which the gift was made.

As the preamble goes on to discuss, the estate tax on the transfer of a decedent’s taxable estate at death is calculated in a five-step computation under Secs. 2001 and 2010, applying the same rate schedule used for gift tax purposes:⁶

1. Determine a tentative tax on the sum of the taxable estate and the adjusted taxable gifts;⁷
2. Determine a hypothetical gift tax on all post-1976 taxable gifts;⁸
3. Determine the net tentative estate tax by subtracting the gift tax payable determined in Step 2 from the tentative tax determined in Step 1;⁹
4. Determine a credit amount (which may not exceed the net tentative estate tax) equal to the tentative tax on the applicable exclusion amount in effect on the date of death;¹⁰
5. Subtract the credit amount determined in Step 4 from the net tentative estate tax determined in Step 3.¹¹

The preamble notes that the exclusion from adjusted taxable gifts of transfers includible in the gross estate does not affect Step 2, and gift tax is payable on all post-1976 taxable gifts, regardless of whether they are included in the gross estate. Because both the hypothetical gift tax and the credit amounts are computed using the gift tax rates in effect at the date of death, when computing estate tax, a credit is provided for all credits provided on includible gifts in the year the gifts were made. This includes credit amounts attributable to the $10 million BEA.

More about the proposed exception

The new proposed regulations would provide an exception to the special rule for includible gifts. This exception was adopted in response to a public comment received on the 2018 proposed regulations that preceded T.D. 9884. The commenter had asked whether a special rule should apply to taxable gifts made during the increased BEA period if the gifts are essentially testamentary and thus included in the gross estate rather than in adjusted taxable gifts.

The preamble to the new proposed regulations explains that the special rule is designed to ensure that bona fide inter vivos property transfers are consistently treated as gifts for purposes of gift and estate tax. The preamble points to a subset of includible gifts — gifts made during the increased BEA period that are essentially testamentary but are deductible for gift tax purposes due to the charitable or marital deduction — to which the special rule does not apply. Inconsistent gift or estate tax treatment will not occur with these gifts because no credits allocable to the gifts would be attributable to the BEA when computing gift tax payable under Sec. 2001(b)(2). With no BEA applicable to the deductible gifts, the increase or decrease of the BEA is of no consequence.

Given that the Code treats certain transfers as testamentary transfers rather than adjusted taxable gifts, the preamble states that it would be inappropriate to apply the special rule to includible gifts, particularly if the transferor retained some right to the transferred property. To prevent this result, the proposed regulations provide an exception to the special rule.

Specifically, Prop. Regs. Sec. 20.2010-1(c)(3) would provide an exception to the special rule for transfers that are includible in the gross estate or treated as includible in the gross estate for Sec. 2001(b) purposes, including:

1. Transfers subject to a life estate or other powers or interests described in Secs. 2035 through 2038 and 2042, regardless of whether the transfer was deductible under Sec. 2522 or 2523;
2. Transfers made by an enforceable promise to pay, to the extent the promise remains unsatisfied at the date of death;
3. Transfers that were subject to Secs. 2701 (regarding special valuation rules of certain transfers of interests in partnerships and corporations) and 2702 (regarding the transfer of income interests in a trust); and
4. Transfers that would have been included in 1, 2, or 3 but for the elimination of that transfer from the gross estate within 18 months of the death of the transferor.

When published in final form, the regulations will apply to estates of decedents dying on or after April 27, 2022, the date the proposed regulations were published in the Federal Register. If the BEA decreases before final regulations are issued, the exception to the special rule contained in the proposed regulations will apply to estates of decedents dying on or after April 27, 2022.

The proposed regulations should not negatively affect a completed gift that does not involve a retained interest. If, however, a donor has made gifts of assets that may have some potential estate tax exposure (e.g., interests in family limited partnerships or a limited liability company under Sec. 2036), the proposed regulations could present a risk of the estate’s receiving the benefit of only the lower BEA at death.

Estate debts and expenses

On June 24, 2022, Treasury and the IRS released proposed regulations¹² under Sec. 2053 that provide guidance on the proper use of present-value principles in determining the amount an estate may deduct for funeral expenses, administration expenses, and certain claims against the estate. In addition, the proposed regulations address the deductibility of certain types of interest expense as well as amounts paid under a decedent’s personal guaranty.

Background

The value of a decedent’s gross estate, less deductions under Secs. 2053 through 2058, is generally the taxable estate that is subject to estate tax under Sec. 2001. Final regulations¹³ issued under Sec. 2053 in October 2009 (the 2009 final regulations) generally limit an estate’s deduction for claims and expenses to the amount actually paid to settle a debt or other claim.

A section of the 2009 final regulations¹⁴ was reserved for future guidance on how present-value principles should be applied in determining the amount the estate may deduct under Sec. 2053. The new proposed regulations represent that guidance.

The proposed regulations also provide or clarify rules under Sec. 2053 on:

• The deductibility of interest expense accruing on tax and penalties that an estate owes;
• The deductibility of interest expense accruing on certain loan obligations that an estate incurred;
• Requirements for substantiating the value of a claim against an estate that is deductible under Regs. Sec. 20.2053-4(b) or (c); and
• The deductibility of amounts paid under a personal guaranty by the decedent.

Applying present-value principles to deductible amounts

The 2009 final regulations implemented the present-value accounting principle in determining the amount that an estate may deduct for certain claims and expenses. They generally limit the Sec. 2053 deduction to the amount actually paid to settle or satisfy a claim or expense and clarify that events occurring after death are considered in determining the allowable Sec. 2053 deduction. To more accurately measure the amounts not passing to heirs and legatees, the IRS determined that the deductible amount should be limited to the present value of the amounts paid after an extended post-death period.

Proposed regulations¹⁵ (the 2007 proposed regulations) that preceded the 2009 final regulations permitted deductions for a decedent’s noncontingent recurring obligations if the present value of future payments under the obligation was computed. In contrast, a decedent’s contingent recurring obligations were deductible only as the estate paid amounts to satisfy the claims — and computing the present value of the amounts was not necessary. Responding to commenters who argued the proposed regulations produced an inconsistent and inequitable result, Treasury and the IRS clarified in the 2009 final regulations that the amount payable under a decedent’s noncontingent recurring obligation is deemed ascertainable with reasonable certainty and, therefore, may be deducted in advance, while the amount payable under a contingent recurring obligation cannot be determined with reasonable certainty and thus is deductible only as paid. The 2009 final regulations also removed the language making the present-value limitation applicable only to noncontingent recurring obligations and reserved the issue for future guidance.

The new proposed regulations generally would apply present-value principles consistently to expenses and claims without regard to whether they are contingent. (Only unpaid mortgages and indebtedness excluded under Regs. Sec. 20.2053-7 would be excluded.) Acknowledging that estates “often cannot pay every deductible claim and expense within a short time after the decedent’s death,” the proposed regulations allow a three-year grace period following the decedent’s death for the estate to pay deductible debts. Therefore, an estate would be required to make a present-value calculation only if a deductible claim or expense is not paid or to be paid by the third anniversary of the decedent’s death.

A general formula in the new regulations determines the present value of these not-yet-paid amounts by applying a discount rate equal to the applicable federal rate determined under Sec. 1274(d) for the month of the decedent’s death, compounded annually for the length of time between the date of death and the anticipated date of payment. The proposed regulations would allow any reasonable assumptions or methodology regarding time period measurements to be used in calculating the present value and require the estate to submit a supporting statement on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, showing how the present value was calculated.

Once finalized, Prop. Regs. Sec. 20.2053-1(d)(6) completes the 2009 revisions to the regulations under Sec. 2053 that set forth the use of post-death events in determining the amount deductible for expenses and claims against the estate. Before the 2009 revisions to the regulations, the courts were split as to whether post-death events had to be taken into account when determining the amount deductible in computing the taxable estate. The new proposed regulation sets forth the use of present-value concepts in determining the amount of the deduction for expenses and claims against the estate, depending on when those expenses and claims will be paid by the estate. The proposed regulations provide a three-year grace period for payment of the expenses and claims before these present-value rules would have to be used. As with the general implications of the 2009 revisions, the deductible amount of expenses and claims against the estate may be lower than their values on the date of the decedent’s death due to post-death events.

Deducting interest expense as estate administration expense: Interest on unpaid tax and penalties

An estate generally must pay interest at the Sec. 6621 underpayment rate on any unpaid federal tax and additions to tax (Sec. 6621 interest). In contrast, interest payable under Sec. 6601 on unpaid estate tax deferred under Sec. 6166 (Sec. 6166 interest) receives a more favorable interest rate under Sec. 6601(j) and is not deductible.

The preamble to the proposed regulations notes that non—Sec. 6166 interest may accrue on or after the date of death on unpaid estate tax in connection with a Sec. 6161 extension, which is granted by showing reasonable cause for extending the time for payment. According to the preamble, Treasury and the IRS consider a Sec. 6163 deferral to be appropriate if the value of a reversionary or remainder interest is includible in the estate but is not immediately available to pay the estate tax.

Although non—Sec. 6166 interest and the underlying underpayment of tax or deficiency is often attributable to executors’ reasonable exercise of their fiduciary duties — and thus incurred in the administration of the estate — the preamble notes that this is not always the case. The proposed regulations would not consider any non—Sec. 6166 interest accruing on an unpaid tax or penalty attributable to an executor’s negligence, disregard of the rules or regulations, or fraud with the intent to evade tax to be: (1) actually or necessarily incurred in the administration of the estate; or (2) essential to the proper settlement of the estate.

Interest on certain estate loan obligations

Parallel issues apply to interest accrued on bona fide loan obligations that the estate incurs. The proposed regulations would permit the estate to deduct interest expense only if:

1. The interest accrued under an instrument or contract that constitutes indebtedness under applicable income tax regulations and general principles of federal law;
2. Both the interest expense and the underlying loan are bona fide in nature; and
3. The underlying loan and its terms are actually and necessarily incurred in the administration of the decedent’s estate and are essential to the proper settlement of the estate.

The proposed regulations provide a nonexclusive list of factors to consider in determining whether interest payable under an estate’s loan obligation satisfies Regs. Secs. 20.2053-1(b)(2) and 20.2053-3(a) and thus is reasonable and comparable to an arm’s-length loan.

Although applicable to estate loans, these proposed regulations appear designed to curtail the use of what the estate planning area generally calls “Graegin loans.”¹⁶ In Graegin, the estate was able to deduct on its estate tax return all the interest due on the estate loan as an administration expense under Sec. 2053.

While the election under Sec. 6166 allows estates to defer the payment of estate tax up to 14 years, it has two potential disadvantages: (1) It does not generally apply to a decedent’s entire estate (just interests in closely held businesses), and (2) the interest charged on the deferred amount of estate tax is not deductible as an expense under Sec. 2053. Graegin loans have neither of these disadvantages: (1) They may apply to the entire estate tax obligation, and (2) the interest is a deductible expense. A Graegin loan is required to be bona fide and “actually and necessarily” incurred. In recent cases, the IRS has successfully argued that Graegin loans were not “actually and necessarily” incurred with regard to liquid assets or family investment partnerships (see, e.g., Estate of Koons¹⁷ Estate of Black¹⁸). These proposed regulations provide guidance as to when Treasury and the IRS will respect estate loan obligations.

Substantiating certain valuations

Although an estate generally may deduct only amounts it actually pays to satisfy a claim, certain exceptions exist. For example, deductions are permitted for the value of (1) claims and counterclaims in a related matter,¹⁹ and (2) unpaid claims totaling $500,000 or less.²⁰ For both exceptions, the claim’s value must be determined from a qualified appraisal performed by a qualified appraiser, as defined under Sec. 170. Noting that qualified appraisals characterized under Sec. 170 pertain to charitable contribution deductions, the preamble explains that the proposed regulations would replace this requirement with new requirements.

Specifically, the proposed regulations would require a written appraisal adequately reflecting the current value of the claim when Form 706 is being completed. The written appraisal should:

• Take into account post-death events occurring before the deduction is claimed and reasonably anticipated to occur afterward;
• Consider all relevant facts and elements of value that are known or can be reasonably anticipated;
• Be prepared, signed, and dated by a person who is qualified to appraise the claim being valued, but not (1) a member of the decedent’s family, a related entity, or a beneficiary of the decedent’s estate or revocable trust; (2) a beneficiary’s family member or related entity; or (3) an employee or owner of any of these individuals or entities; and
• Describe the basis for the appraiser’s qualifications to appraise the claim.

The apparent reason for these proposed regulations is twofold: (1) the realization that the definition of qualified appraiser and qualified appraisal under Sec. 170 pertain to charitable contributions of property and not to claims against the estate (and, therefore, are not entirely compatible); and (2) the requirement that the appraiser consider, and the appraisal reflect, post-death events in determining the amount deductible as a claim against the estate.

Deducting amounts paid pursuant to a decedent’s personal guaranty

A commenter on the 2007 proposed regulations suggested the final regulations confirm that payments made based on a decedent’s personal guaranty are deductible in the same manner as payments made to satisfy any other deductible claim against the estate. For a claim that is based on a decedent’s guaranty to meet the “adequate and full consideration in money or money’s worth” requirement, the preamble to the new proposed regulations notes that the guaranty must have provided the decedent with “a benefit reducible to money value.”

The new proposed regulations therefore provide guidance on whether, for Sec. 2053 purposes, a guarantor agreement is contracted for adequate and full consideration in money or money’s worth. For instance, the regulations would require a claim based on the decedent’s personal guaranty of another’s debt to satisfy the applicable requirements in Sec. 2053(c)(1)(A) and Regs. Sec. 20.2053-4(d)(5). That is, the guaranty must have been bona fide and in exchange for adequate and full consideration in money or money’s worth.

A bright-line rule would deem a decedent’s guaranty of a bona fide debt of an entity that the decedent controlled when the guaranty was made to satisfy the adequate-and-full-consideration requirement.²¹ The requirement would also be met if, when the guaranty is given, the decedent’s maximum liability under the guaranty did not exceed the fair market value (FMV) of the decedent’s interest in the entity. To the extent that the estate had a right of contribution or reimbursement for the decedent’s guaranty, the deductible amount would be reduced under Regs. Sec. 20.2053-1(d)(3).

In short, the proposed regulations provide guidance as to whether a payment made on a decedent’s personal guaranty is deductible as a claim against the estate. The main requirement is that it be bona fide and that the decedent receive adequate and full consideration in money or money’s worth — e.g., the decedent receives a guaranty fee for his or her personal guaranty. In many instances involving personal guaranties among family members or related parties, the guarantor is uncompensated for his or her personal guaranty. If that is true, the decedent’s estate would not be able to deduct the claim associated with the personal guaranty even if the decedent’s estate had to pay the claim.

Portability extension of time

In Rev. Proc. 2022-32, the IRS updated a simplified method to obtain an extension of time to file a return to elect portability of the deceased spousal unused exclusion (DSUE) amount.²² The revenue procedure applies to estates not normally required to file estate tax returns because the gross estate’s value falls below the Sec. 6018(a) filing threshold. The revenue procedure extends the time in which a decedent’s estate may make the portability election under the simplified method to on or before the fifth anniversary of the decedent’s death.

Background

Before 2011, married couples could not preserve any unused lifetime applicable exclusion amount of the first-to-die spouse. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010²³ (the 2010 Tax Act) amended Sec. 2010(c) to allow portability of the applicable exclusion amount between spouses. When a spouse died in 2011 or 2012, the 2010 Tax Act allowed the surviving spouse to add to his or her own applicable exclusion amount the deceased spouse’s unused applicable exclusion amount available at death. This provision was set to expire on Dec. 31, 2012, but the American Taxpayer Relief Act of 2012²⁴ made portability permanent.

In June 2012, Treasury and the IRS issued temporary and proposed regulations²⁵ on the requirements for electing portability of a DSUE amount. Final regulations²⁶ were issued in June 2015 on the estate and gift tax applicable exclusion amount, as well as the requirements for electing portability of a DSUE amount to the surviving spouse. Largely adopting the proposed regulations issued in 2012, the final regulations apply to estates of decedents dying on or after June 12, 2015.

Under Sec. 2010(c), the basic exclusion amount is defined as $5 million, adjusted for inflation each year after 2011.²⁷ The DSUE amount is the lesser of: (1) the basic exclusion amount; or (2) the excess of the applicable exclusion amount of the surviving spouse’s last-deceased spouse over the amount with respect to which the tentative tax is determined under Sec. 2001(b)(1) on the estate of the deceased spouse.²⁸

In addition, the executor of the estate of the deceased spouse must elect portability of the DSUE amount on a timely filed estate tax return, and the return must include a computation showing how the amount was calculated.²⁹

The due date for an estate tax return on which a portability election is made is nine months after the date of death or the last day of an extension period if an extension of time to file was obtained.³⁰ An extension of time to elect portability will not be granted to an estate that must file an estate tax return under Sec. 6018(a).³¹ But an extension to elect portability under Sec. 2010(c)(5)(A) may be available under Regs. Sec. 301.9100-3 to an estate that is not required under Sec. 6018(a) to file an estate tax return.

Previous relief for failure to timely elect portability

In Rev. Proc. 2014-18, the IRS provided a simplified method, available until Dec. 31, 2014, for obtaining an automatic extension of time to elect portability for estates of decedents that had surviving spouses and were not required to file an estate tax return. Since Dec. 31, 2014, the IRS has issued numerous private letter rulings granting extensions of time to elect portability for estates not required under Sec. 6018(a) to file an estate tax return.

Rev. Proc. 2017-34 extended the time available for the estate of a decedent to elect portability under the simplified method to the later of Jan. 2, 2018, or the second anniversary of the decedent’s death. The IRS cited the significant burden of processing the numerous requests by estates for an extension of time to make a portability election.

Additional relief in the new revenue procedure

Rev. Proc. 2022-32 states that continuing relief is needed for estates that are not required to file an estate tax return, as the IRS continues to receive a considerable number of requests for extensions of time to elect portability, placing a significant burden on the agency. Further, the IRS has observed that a significant percentage of the requests have come from estates where the decedent has died within five years of the request date. Therefore, for estates that are not required to file an estate tax return, the revenue procedure extends the period under the simplified method to obtain an extension of time to elect portability to on or before the fifth anniversary of the decedent’s death. After this period expires, a taxpayer may seek relief by requesting a private letter ruling under Regs. Sec. 301.9100-3.

If an estate that has obtained relief under Rev. Proc. 2022-32 is later determined to be an estate for which an estate tax return should have been filed under Sec. 6018(a), the grant of an extension is deemed null and void ab initio.

If the decedent’s estate is granted relief under Rev. Proc. 2022-32 and the estate tax return is considered timely filed for purposes of electing portability, the DSUE amount of the decedent is available to his or her surviving spouse or the spouse’s estate for application to the surviving spouse’s transfers made on or after the decedent’s date of death in accordance with the rules prescribed under Regs. Secs. 20.2010-3 and 25.2505-2. However, if the increase in the surviving spouse’s applicable exclusion amount attributable to the addition of the decedent’s DSUE amount causes the surviving spouse or his or her estate to overpay gift or estate tax, no claim for credit or refund may be made if the Sec. 6511(a) time for filing a claim for credit or refund of a tax overpayment has expired. Rev. Proc. 2022-32 includes a provision enabling an estate to file a protective claim for credit or refund of tax in anticipation of relief under the revenue procedure and provides three examples illustrating how to apply the revenue procedure.

Although Rev. Proc. 2022-32 is designed to free up resources at the IRS to focus on more substantive matters, it also relieves certain estates of the burden of having to file for a private letter ruling to request an extension of time to make a portability election — at least if the estate realizes within five years of the decedent’s death that it may make the election by filing an estate tax return. If the estate fails to realize this omission within five years of the decedent’s death, it can still request a private letter ruling to obtain relief for an extension of time to make a portability election. This revenue procedure does not provide any relief, however, for estates that were otherwise required to file a return under Sec. 6018(a).

Estate tax inclusion

In Connelly,³² a district court held that when one of the two co-owners of a business died and the company received life insurance proceeds in connection with a buy-sell agreement, those insurance proceeds should be counted in determining how much the decedent’s shares in the company were worth for purposes of his estate tax.

Background

Brothers Michael and Thomas Connelly were the only shareholders in Crown C Supply Inc., a closely held family business. Before his death on Oct. 1, 2013, Michael was the president, CEO, and majority shareholder. Together, Crown C had 500 shares outstanding, with Michael owning 385.90 shares (77.18%) and Thomas owning 114.10 shares (22.82%).

In 2001, to maintain family ownership and control over the company and to satisfy their estate planning objectives, the brothers and Crown C signed a stock purchase agreement (SPA). Under the SPA, on the death of one of the brothers, the surviving brother had the right to buy the decedent’s shares, and, if the surviving brother did not purchase those shares, Crown C was required to redeem or buy the shares. Crown C bought $3.5 million in life insurance policies on both brothers to provide funding for its redemption obligation.

Article VII of the SPA provided two methods for calculating the price at which Crown C would redeem the shares. Article VII specified that the brothers “shall, by mutual agreement, determine the agreed value per share by executing a new ‘Certificate of Agreed Value’ at the end of every tax year.” If the brothers did not execute a certificate of agreed value, they would determine the “appraised value per share” by securing two or more appraisals. The brothers never signed a certificate of agreed value under the SPA.

On Oct. 1, 2013, Michael died, and Crown C received approximately $3.5 million in life insurance proceeds. Thomas chose not to buy Michael’s shares, so Crown C used a portion of the life insurance proceeds to buy Michael’s shares from his estate. Crown C and the estate did not have Michael’s shares appraised as required by the SPA and instead entered into a sale-and-purchase agreement for $3 million. By way of the sale agreement, (1) the estate received $3 million in cash; (2) Michael P. Connelly Jr., Michael’s son, secured a three-year option to purchase Crown C from Thomas for $4,166,666; and (3) in the event Thomas sold Crown C within 10 years, Thomas and Michael Jr. agreed to split evenly any gains from the future sale.

Thomas, as executor of Michael’s estate, filed an estate tax return for the estate. He included an amount in the estate for Michael’s Crown C shares of $3 million. On audit, the IRS challenged the $3 million valuation of Michael’s Crown C shares. The IRS determined that Crown C’s date-of-death FMV should have included the $3 million in life insurance proceeds used to redeem the shares, resulting in a higher value for Michael’s Crown C shares than reported on the estate’s return.

The IRS issued a notice of deficiency, assessing over $1 million in additional estate taxes. As part of the IRS audit, the estate obtained a report on Crown C’s value from an accounting firm concluding that the inclusion of the insurance proceeds in the value of Crown C resulted in the value of the company being overstated by $3 million. Thomas paid the additional assessment of $1 million and filed suit on behalf of the estate, seeking a refund of the $1 million. The parties stipulated that, if the estate was due a refund, for the purpose of determining the amount of such refund, the FMV of Michael’s Crown C shares was $3.1 million as of Oct. 1, 2013 (the date of his death). The stipulation expressly did not take into account the dispute over how to account for the life insurance proceeds used to redeem Michael’s shares, so the stipulation only controlled the value of Crown C exclusive of those life insurance proceeds.

The estate argued that the SPA determined Crown C’s value for estate tax purposes, so the district court need not determine Crown C’s FMV. The estate argued, alternatively, that Crown C’s FMV did not include $3 million of the life insurance proceeds because the SPA created an offsetting $3 million obligation for Crown C to redeem Michael’s shares. The IRS argued that the SPA did not meet the requirements under the Code, the regulations, and the applicable case law to control Crown C’s valuation, and that under applicable law and customary valuation principles, the life insurance proceeds used to redeem Michael’s shares increased Crown C’s FMV by $3 million.

The district court first addressed whether the SPA set the value of Michael’s shares for estate tax purposes, concluding that it did not. The court next analyzed whether the life insurance proceeds should be considered when calculating Crown C’s value, concluding that they should.

Whether the SPA set the value: First part of the analysis

On the question of whether the SPA set the value of Michael’s shares for estate tax purposes, the first issue addressed by the district court was whether Sec. 2703(a) applied. Sec. 2703(a) states that the FMV of an interest in a company is determined without regard to a buy-sell agreement. However, Sec. 2703(b) provides an exception to Sec. 2703(a) if the agreement: (1) is a bona fide business arrangement; (2) is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and (3) is comparable to similar agreements entered into by persons in an arm’s-length transaction. Here, the district court determined, based on an analysis of these three prongs, that the Sec. 2703(b) exception was inapplicable.

Regarding whether the SPA was a bona fide business arrangement, the parties stipulated that the Connelly brothers entered the SPA for the purpose of ensuring continued family ownership over Crown C. Based on the parties’ stipulation, the district court deemed the SPA a bona fide business arrangement.

Regarding whether the SPA was a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth, the district court determined that the estate failed to show that the SPA was not a device to transfer wealth to Michael’s family members for less than full and adequate consideration. First, the $3 million redemption price was not full and adequate consideration. The parties’ stipulation explicitly left aside the life insurance issue when it otherwise agreed to the $3.1 million value of Michael’s Crown C shares. Second, even though Crown C fulfilled the purpose of the agreement by redeeming Michael’s shares, Thomas and the estate’s process in selecting the redemption price showed that the SPA was a testamentary device. In addition, the SPA’s lack of a minority discount for Thomas’s shares and corresponding lack of a control premium for Michael’s shares substantially overvalued Thomas’s shares and undervalued Michael’s shares. The court found that, while the Connelly brothers’ good health when they executed the SPA weighed in favor of the estate’s argument, the parties’ total disregard of the SPA and the lack of a control premium or minority discount in it showed that the SPA was a testamentary device to transfer wealth to Michael’s family members for less than full and adequate consideration.

Regarding whether the SPA was comparable to similar arrangements negotiated at arm’s length, the district court determined that, other than the accountant’s report, the estate failed to provide any evidence of similar arrangements negotiated at arm’s length. The court added that the fact that closely held family corporations generally use life insurance proceeds to fund redemption obligations does not establish that this particular SPA was comparable to an arm’s-length bargain, particularly when the $3 million valuation was so far below FMV. The court also observed that, here, the SPA’s prohibition of control premiums or minority discounts resulted in an undervalued majority interest for Michael’s shares. Thus, the SPA was not found to be comparable to similar arrangements negotiated at arms’ length.

Whether the SPA set the value: Second part of the analysis

On the question of whether the SPA set the value of Crown C, the second issue addressed by the district court was whether the SPA met the requirements of Regs. Sec. 20.2031-2(h). Pursuant to Regs. Sec. 20.2031-2(h), a buy-sell agreement must meet the following requirements: (1) The offering price must be fixed and determinable under the agreement; (2) the agreement must be legally binding on the parties both during life and after death; and (3) the agreement must have been entered for a bona fide business reason and must not be a substitute for a testamentary disposition for less than full and adequate consideration. The district court found that the SPA did not meet these requirements.

Regarding whether the purchase price was fixed and determinable, the district court concluded that Crown C’s share price was not fixed and determinable. It noted that the $3 million redemption price was not determined under a formula in the SPA, and Thomas and the estate did not rely, as required by the SPA, on a certificate of agreed value or two or more appraisals to determine Crown C’s share price. Instead, Thomas and the estate negotiated their own value, which, the court noted, “not surprisingly was less than the value of the life insurance proceeds.”

Regarding whether the SPA was legally binding on the parties during life and after death, the district court focused on whether it was binding after death. The court noted that the conduct of Thomas and the estate demonstrated that the SPA was not binding after Michael’s death. The court noted that the parties failed to determine Crown C’s share price through the formula set forth in the SPA. Also, the sales price of the shares was set without obtaining any appraisals for Crown C. Finally, the court surmised that the likely explanation for Thomas’s and the estate’s not abiding by the SPA was that the formula in the SPA would have resulted in a value of Michael’s shares of Crown C much higher than $3 million.

Regarding whether the SPA was entered into for a bona fide business reason and not as a substitute for a testamentary disposition, the district court noted that it had already determined the SPA was not entered into for those reasons in its Sec. 2703 analysis and need not address them again.

Ultimately, then, the district court concluded that the SPA did not establish Crown C’s value for estate tax purposes.

Life insurance proceeds and Crown C’s value

Having concluded that the SPA did not set the value of the deceased’s shares for estate tax purposes, the court analyzed whether the insurance death benefit should be considered when calculating the corporation’s value for estate tax purposes. The IRS argued that the court should reject the Eleventh Circuit’s holding in Estate of Blount³³ and apply the Tax Court’s reasoning in that same case.³⁴In the IRS’s view, the Eleventh Circuit’s approach violated customary valuation principles and would result in a below-market valuation for Crown C and a windfall for Thomas at the expense of Michael’s estate. Per the IRS, a willing buyer and seller would value Crown C at approximately $6.86 million rather than $3.86 million because, on the date of Michael’s death, Crown C possessed the $3 million in life insurance proceeds that were later used to redeem Michael’s shares.

The district court rejected the appellate court’s approach in Blount, finding it contained an analytical flaw. The court determined that the appellate court in Blount had misread Regs. Sec.20.2031-2(f)(2) and that the regulation specifically requires consideration to be given to nonoperating assets including life insurance proceeds “to the extent such nonoperating assets have not been taken into account in the determination of net worth.” The court found that the text of the regulation does not indicate that the presence of an offsetting liability means that the life insurance proceeds have already been taken into account in determining a company’s net worth.

The district court determined that, under its plain terms, the regulation means that the life insurance proceeds should be considered in the same manner as any other nonoperating asset in calculating the FMV of a company’s stock. Further, a redemption obligation is not the same as an ordinary corporate liability. The court added that there is a difference between a redemption obligation that simply buys shares of stock and one that also compensates for a shareholder’s past work. One that only buys stock is not an ordinary corporate liability since it does not change the value of the corporation as a whole before the shares are redeemed. It involves a change in the ownership structure, with a shareholder essentially “cashing out.”

The court noted that the parties had stipulated that the decedent’s shares were worth $3.1 million, aside from the life insurance proceeds. Because the insurance proceeds were not offset by the company’s redemption obligation, the FMV of the company at Michael’s date of death and of Michael’s shares included all of the insurance proceeds. Accordingly, the district court upheld the IRS’s position and granted its motion for summary judgment.

Footnotes

¹T.D. 9957.

²REG-118913-21.

³P.L. 115-97.

⁴Sec. 2010(c)(3).

⁵Sec. 2001(b) excludes from “adjusted taxable gifts” any gifts that are includible in the gross estate. Similarly, Sec. 2701(e)(6) and Regs. Sec. 25.2701-5 remove from adjusted taxable gifts any transfers includible in the gross estate that had already been subject to the Sec. 2701 special valuation rules.

⁶As stated in the preamble to the proposed regulations under Sec. 2010 on Nov. 23, 2018, REG-106706-18.

⁷Sec. 2002(b)(1).

⁸Secs. 2001(b)(2) and (g).

⁹Sec. 2001(b).

¹⁰Secs. 2010(a) and (c).

¹¹Sec. 2010(a)

¹²REG-130975-08.

¹³T.D. 9468.

¹⁴Regs. Sec. 20.2053-1(d)(6).

¹⁵REG-143316-03.

¹⁶Referring to Estate of Graegin, T.C. Memo. 1988-477.

¹⁷Estate of Koons, T.C. Memo. 2013-94.

¹⁸Estate of Black, 133 T.C. 340 (2009).

¹⁹Regs. Sec. 20.2053-4(b).

²⁰Regs. Sec. 20.2053-4(c).

²¹Under Sec. 2701(b)(2).

²²See Regs. Sec. 301.9100-3 and Sec. 2010(c)(5)(A).

²³Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.

²⁴American Taxpayer Relief Act of 2012, P.L. 112-240.

²⁵T.D. 9593 and REG-141832-11.

²⁶T.D. 9725.

²⁷Sec. 2010(c)(3).

²⁸Sec. 2010(c)(4).

²⁹Sec. 2010(c)(5).

³⁰Regs. Sec. 20.2010-2(a)(1).

³¹Regs. Sec. 20.2010-2(a)(1).

³²Connelly, No. 4:19-cv-01410 (E.D. Mo. 9/21/21).

³³Estate of Blount, 428 F.3d 1338 (11th Cir. 2005), rev’g in part T.C. Memo. 2004-116.

³⁴Estate of Blount, T.C. Memo. 2004-116.

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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