2005 Gift and Estate Tax Decisions of Note

The Tucker Act, 28 U.S.C. §1491 (1887), granted the U.S. Claims Court jurisdiction to “render judgment upon any claim against the United States founded . . . upon the Constitution,” waiving sovereign immunity with respect to lawsuits arising out of express or implied contracts to which the government was a party. Suits may be brought for Constitutional claims seeking a refund of taxes.

In Clinton Elkhorn Mining Co.,
SCt. 2008-1 USTC ¶50,281, the taxpayer sought a refund for Coal Tax collected in violation of the Export Clause of the Constitution. IRC §7422(a) provides that “no suit or proceeding shall be maintained in any cout for the recovery of any internal revenue tax . . . until a claim for refund or credit has been duly filed.” Under IRC §6511(a), a refund claim must be filed within three years of the date of filing of the return, or within two years of when the tax was paid, if later.

The taxpayer argued that the Code’s refund scheme was “constitutionally dubious” and that the refund rules did not apply to taxes are unconstitutional on their face. The Court rejected both arguments. The appearance of the word “any” five times: “any court,” “any internal revenue tax,” “any sum,” “in any manner,” indicated that Congress intended the state to be expansive. Furthermore, the language “any manner wrongfully collected” applied provision subsequently held unconstitutional.

IRC § 2036 emerged as a potent IRS weapon against FLP valuation discounts. The 5th Circuit in Estate of Strangi, 417 F.3d 468 affirmed the Tax Court’s decision that partnership assets over which the decedent had retained beneficial enjoyment were includible in the estate pursuant to §2036(a)(1). Further, while the transfer of FLP interests to his children may have been for full and adequate consideration, no “substantial business or other non-tax purpose” existed and no bona fide sale occurred. Since the decedent also controlled beneficial enjoyment by others, inclusion also resulted pursuant to §2036(a)(2).

Sec. 2036(a)(1) also resulted in inclusion in Estate of Abraham, 408 F.3d 26 (1st Cir.), where the the Tax Court found an implied agreement that the decedent’s needs were actually treated as a partnership obligation. The 1st Circuit, affirming, also found that (i) the children’s purchase of partnership units were not bona fide sales since the decedent’s guardian could divert partnership income to the decedent; and (ii) the estate had not established that the children paid adequate consideration for their interests.

Estate of Bongard, 124 T.C. 95, found an implied agreement to retain a lifetime benefit from the partnership, thus precluding the possibility of a bona fide sale for adequate consideration. The opinion emphasized that the nontax reason for the family partnership must be a significant factor and not merely a theoretical justification. Similarly, in Estate of Bigelow, T.C. Memo 2005-65, the Tax Court, noting that the decedent had transferred so much of her property to the partnership that she was unable to support herself, found an implied agreement that the decedent would retain beneficial enjoyment of partnership assets. The decedent was trustee of a trust which was the sole general partner of an FLP of which the children were limited partners.

However, in Estate of Schutt, T.C. Memo 2005-13, the Tax Court found that neither § 2036(a)(1) nor § 2038 applied to a decedent’s transfer of substantial assets to business trusts. His desire to perpetuate investment philosophy was a legitimate purpose of the transaction, intending to protect the family’s wealth by providing for centralized management of the family’s holdings in duPont stock.

To reduce the risk of challenge under § 2036(a)(1) or (a)(2), the following points should be considered:

¶ Avoid commingling of partnership and personal assets;

¶  Retain sufficient assets so that no agreement granting the donor enjoyment rights over the transferred assets may be reasonably implied;

¶   Report management fees paid to the donor or children and pay self-employment taxes associated therewith;

¶ Ensure that limited partnership interests are acquired by cash or property transfers and that such purchases are documented;

¶  Allow a reasonable period of time to elapse before gifted cash is used to purchase limited partnership interests;

¶ Commence planning when the donor is in reasonably good health if possible, since testamentary transfers are more likely to fall prey to an IRS claim of a lack of a bona fide sale;

¶ Avoid permitting the donor to be the sole general partner or the sole managing member; and

¶ Prohibit non-prorata distributions.

Taxpayers fared better in cases where only the size of the discount was in issue. In Estate of Baird, 416 F.3d 442, the Estate claimed a 60% discount for lack of marketability. The IRS argued that only a 5% discount attributable to the cost of partitioning the timberland property, was appropriate. The 5th Circuit affirmed a Tax Court decision allowing a 60% discount, and further, finding the government’s position not substantially justified, allowed an award of attorney’s fees.

In Estate of Kelly, T.C. Memo 2005 235, a 32.24% valuation discount was allowed for an FLP holding only cash and certificates of deposit. The court allowed a 12% minority discount, reflecting the members’ lack of control, and a 23% marketability discount, reflecting the lack of a market for the closely held limited partnership interests. The case seems to refute the notion that FLPs holding only marketable securities cannot produce substantial discounts.

In Estate of Jelke, T.C. Memo, 2005-131, the discount for unrecognized capital gains recognized in Eisenberg (2nd Cir., 1998), Jameson (5th Cir. 2001) and Dunn (5th Cir. 2002) was reduced to reflect the likelihood that the company would not be liquidated for many years. The decision seems questionable, since it is appears to be settled law that in valuing assets for estate tax purposes, only those factors existing on the date of death should be considered. An appeal has been filed with the 11th Circuit.

Estate of Kahn, 125 T.C. No. 11, held that the estate tax value of IRAs may not be discounted for income taxes. The court noted that the issue of double taxation is adequately addressed by §691(c), which provides an income tax deduction for estate tax imposed on items of income in respect of a decedent (IRD).

In Estate of Senda, 88 TCM 8 (2004), the Tax Court refused to allow valuation discounts for gifts of FLP interests where the formation of the FLP and the gifts were contemporaneous. The Tax Court found that the transfer of stock to the FLP and the immediate gift of FLP interests were part of an integrated transaction to which the step transaction doctrine applied.

While acknowledging that a buy-sell agreement was a bona fide business arrangement, Estate of True, 390 F.3d 1210, nevertheless held that the agreement was not binding for estate tax purposes, since its testamentary intent was to transfer business interests to natural objects of the decedent’s bounty for less than adequate and full consideration. Similarly, Smith v. U.S., 2005-2 USTC ¶60,508 (W.D. Pa.) held that restrictions in the partnership buy-sell agreement should be disregarded in determining the value of gifted interests, since the taxpayer-donor had retained the unilateral ability to amend or modify the partnership agreement.

Estate of Tehan, T.C. Memo 2005-128 illustrates that business agreements among family members may be subject to close IRS scrutiny. The Tax Court held that the value of decedent’s condominium was includible in his estate where his children permitted him to live rent-free in exchange for his payment of real estate taxes, mortgage and maintenance. Since fair market value of rent substantially exceeded the costs being borne by the decedent, the court had little difficulty distinguishing Estate of Barrow, 55 T.C. 666 (1971), a case in which the decedent gave property to his children but rented it back at fair rental value.

Estate of Davies, 394 F.3d 1294 (9th Cir.), aff’g, T.C. Memo 2003-55 denied both a QTIP and general power of appointment marital deduction to a trust which failed to grant the surviving spouse the required lifetime income interest. The 9th Circuit rejected the argument that the trust’s failure was cured by California law, which construes a trust in light of a testator’s intent that the gift qualify for the marital deduction. Here, the trust failed to state an intent that the gift qualify for the marital deduction.

A different result was reached in  Sowder v. U.S., __F. Supp.2d __, No. CV-02-0136-WFN (E.D. Wash), where the IRS also denied a marital deduction. Washington state law requires that a bequest intended to qualify for the marital deduction be so construed. In this case, the decedent’s intent that the gift qualify for the marital deduction was established through contemporaneous estate planning documents. The foregoing cases demonstrate the importance of including in the will or trust document an explicit statement to the effect that the testator (or grantor) intends that the marital share qualify for the federal estate tax marital deduction.

In Matter of Goetz, 793 N.Y.S.2d 318, the court held that the taxpayer’s agent, who held a power of attorney, could not amend a revocable trust created by the principal. To eliminate this problem, the trust should explicitly permit an amendment by exercise of power of attorney provided the power of attorney itself specifically refers to amending the trust.

Under Tax Court procedure, a special trial judge often writes an opinion that is adopted by the trial judge, who may modify the opinion without disclosing this to the taxpayer. The taxpayer does not have access to the special trial judge’s opinion. The Supreme Court, in Ballard, 95 AFTR2d 2005-1302, held that the Tax Court may not exclude from the record on appeal reports submitted by the special trial judge, noting that no statute authorized such concealment, and the Tax Court’s own rules did not warrant such concealment. In response to the Supreme Court’s admonishment, the Tax Court has proposed that under Proposed Rule 183, the special trial judge’s recommended findings of fact and conclusion of law be filed and served on the parties, with a reasonable opportunity provided to file exceptions to such findings.

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