2002 Gift and Estate Tax Decisions of Note

The viability of and the discounts attributable to interests in family entities were again the subject of considerable litigation in 2002. The Fifth Circuit in Estate of Strangi, 293 F.3d 279, affirmed the Tax Court’s holding that Strangi’s estate planning motives did not negate the FLP’s business purpose, and that the entity was valid for estate tax purposes. However, the court reversed the Tax Court on its denial of an IRS motion to amend its answer before trial to add a claim that FLP assets should have been included in the estate under IRC § 2036(a). In remanding, the Fifth Circuit noted that section 2036 could apply if the decedent retained control over the assets. This observation, albeit couched in dicta, does not seem to augur well for the Estate of Strangi and other family entities.

The Tax Court, in Estate of Dailey, 82 TCM 710 allowed a 40 percent discount for an FLP whose assets consisted of appreciated stock in Exxon, AT&T and Bell South.

IRC § 2053 permits deductions for administration expenses “allowable by the laws of the jurisdiction . . . under which the estate is being administered.”  Estate of Grant, 294 F.3d 352 held that deductibility under section 2053 is predicated upon qualification as an administration expense under both the applicable state and federal law.

The Tax Court, in Hackl, 118 T.C. 279, held that gifts of certain LLC interests did not qualify for the annual exclusion under IRC § 2503(b) since they were not gifts of present interests. Restrictions in the operating agreement caused the transfers to fall “short of conferring on the donees the requisite immediate . . . rights to the use, possession, or enjoyment of property or the income from property.”

Skirmishing over GRATs continued in 2002. The Tax Court decided in Schott, 81 TCM 1600 (2001), that a spousal revocable interest commencing on the death of the grantor prior to the termination of a GRAT does not reduce the amount of the taxable gift upon the creation of the GRAT. The decision has been appealed to the Ninth Circuit, historically an inhospitable venue for the Service.

There are unmistakable signs that the halcyon days of sales to defective grantor trusts, a favorite technique of estate planners over the past few years, may be nearing an end, as these sales face increased IRS scrutiny. Although the identity of the taxpayer was not revealed, it was disclosed in early January at the University of Miami Heckerling Estate Planning Conference that a Tax Court petition involving a sale of assets to a defective grantor trust will soon be filed. It appears that the Service has raised the issue of why a seller in an arm’s length transaction would enter into a sales agreement with a trust without requiring adequate collateral.

Professor Carlyn S. McCaffrey of NYU Law School, an advocate of GRATs, suggested in Miami that the estate tax benefit of a sale of assets to a defective grantor trust — which consists of the differential between the growth rate of the assets sold and the IRC § 7520 rate (120% of the federal mid-term rate) — could also be achieved by what amounts to writing a call on the appreciation component of the assets between the grantor and a trustee of the grantor trust. It is difficult to conceive of what business purpose could attach to such a transparently tax-motivated transaction.

The Supreme Court, in U.S. v. Craft, 122 S.Ct. 49 (1999) held that a tenancy by the entirety in real property constitutes “property” under IRC § 6321. Thus, a federal tax lien, arising from an unsatisfied income tax liability, attached to the husband’s interest in the property. Following Craft, U.S. v. Botefuhr, 309 F.3d 1263 (2002) decided the issue of whether a donee is liable for gift tax, and for how long. The Tenth Circuit first determined that a special tax lien attaches to gifts for a period of 10 years from the date of the gift under the first sentence of IRC § 6324(b). If the donor fails to pay the tax, the second sentence then imposes gift tax liability upon the donee. However, since the second sentence does not provide for a period of collection, the court determined that reference must be made to IRC § 6502. IRC § 6502 establishes a 10-year period, after assessment, during which the IRS may collect gift tax liability from the donee. To illustrate the breadth of the Botefuhr holding, assume donor makes a $5 million gift in 2003, files a timely gift tax return, and dies in 2005, without having satisfied the entire gift tax liability. Under Botefuhr, the IRS could make a timely assessment against the estate until 2006, and could collect the tax from the estate — or if the estate failed to pay, from the donee — until 2016.

The Uniform Principal and Income Act (1997) has been adopted in 26 states, including New York. Five states, also including New York, have enacted statutes enabling trusts to adopt a “unitrust” definition of income. Thus, EPTL 11-2.3(b)(5)(A) provides that where the terms of a trust describe the amount that “may or must be distributed to a beneficiary by referring to the trust’s income, the prudent investor standard also authorizes the trustee to adjust between principal and income to the extent the trustee considers advisable. . .”

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