2007 Estate and Gift Tax Decisions of Note

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The 11th Circuit, reversing the Tax Court, held that an estate properly reduced the value of the decedent’s interest in a company holding marketable securities by the company’s entire $51 million built-in capital gain tax liability. Estate of Jelke Est. v. Com’r, __ F.3d __, 2007 WL 3378539 (11th Cir. 11/16/07), rev’g, T.C. Memo 2005-131. The Tax Court had discounted the capital gains tax liability to reflect the likelihood that stocks owned by the company would not be liquidated for many years following the decedent’s death.

The court of appeals found that the Tax Court’s choice of a 16-year period to reflect when the corporation would sell all of its marketable securities at the present turnover rate was not “persuasive” since “[w]e are dealing with hypothetical, not strategic, willing buyers and willing sellers. As a threshold assumption, we are to proceed under the arbitrary assumption that a liquidation takes place on the date of death.
Assets and liabilities are deemed frozen in value on the date of death and a “snap shot” of value taken.” The appeals court upheld the Tax Court’s determination that the claimed minority discount of 25% and the claimed marketability discount of 35%, should be reduced to 10% and 15%, respectively.

An estate which owned a one-half interest in 19 valuable paintings claimed a 44% discount for lack of marketability and control, resulting in a reported value of $1.42 million. Stone v. U.S., 2007 WL 1544786, 99 AFTR2d 2007-2992 (N.D. Ca. 5/25/07) (slip opinion), final opinion 2007 WL 2318974, 2007 TNT 158-15 (N.D. Ca. 8/10/07) (slip opinion). The IRS valued the decedent’s interest at 50% of the value of the entire collection. The District Court agreed that a discount should be allowed, but that it should be substantially less than the 44% claimed.

The court found persuasive the testimony of the IRS Art Advisory Panel, comprised of a collection of unpaid art experts, which based its valuation on comparable sales of similar paintings near the date of valuation. Rejecting the estate’s analogy to discounts allowed for sales of undivided interests in real estate, the District Court agreed with the IRS contention that the only discount allowable was a 2% discount for partition. The court reasoned that a hypothetical willing seller of an undivided interest in art would likely seek to sell the entire work of art and divide the proceeds by partition, rather than sell its fractional interest at a discount.

The IRS was successful in 2007 in a number of cases involving valuation discounts in the context of transfers to family limited partnerships. The Service continued to rely on IRC §2036 to pull back into decedents’ estates assets nominally transferred to FLPs but in which the decedents continued to retain possession, enjoyment or the right to income from the transferred assets.

In Estate of Gore, the inter vivos transfer of assets to the FLP was never completed, since the formalities of transfer were not observed. While bank accounts and stock certificates were purportedly transferred to an FLP, names were not changed on any of the accounts, and Gore continued to collect income and dividends from the assets. T.C. Memo. 2007-169 (June 27, 2007).

In Estate of Erickson, the partnership agreement contemplated that assets would be transferred to the FLP when the operating agreement was executed. However, transfers were not made to the FLP until two days before the decedent’s death, suggesting that partnership formalities had not been observed. Finding that Erickson had retained the benefit of the assets during her lifetime, and that no independent non-tax purposes existed for creating the partnership, the assets were includible in her estate under IRC §2036(a)(1). The court found that the partnership’s purchase of assets from the estate to meet estate tax liabilities was also tantamount to the funds being available to the decedent. T.C. Memo. 2007-107 (April 30, 2007).

Estate of Korby posed a different problem: distributions from the partnership were found to have been made under the pretext of “management fees,” since no written management agreement concerning those fees was ever executed. Moreover, no record of management fees paid was kept, no management income was ever reported, and the management fees paid were greatly in excess of the amounts distributed to the limited partners. Since Korby had retained practically nothing outside the partnership, the Tax Court found an implied agreement that the assets transferred to the partnership would continue to be made available to Korby and her spouse during their lifetime. Thus, the “management fees” constituted an income interest which caused the assets transferred to the FLP to be includible in Korby’s estate under IRC §2036(a)(1). 471 F.3d 848 (8th Cir. 2007).

Rounding out the significant partnership cases, Estate of Bigelow, decided by the 9th Circuit, held that Virginia Bigelow had retained an economic interest in residential real property transferred to an FLP, since the property secured a debt for which Bigelow was personally liable. Another problem was that the partnership continued to make monthly debt payments for Bigelow. Finding an implied agreement to retain both the economic benefits (loan security) and the right to income (loan payments), the real property was includible in Bigelow’s estate under IRC §2036. 503 F.3d 955 (2007).

Tax payment clauses are important, but often overlooked, provisions in testamentary trusts and wills. The decedent in Estate of Sowder bequeathed $600,000 to persons other than his spouse, and left the residue of his estate to his wife, Marie “if she survives me, and is she does not survive me, or dies before my estate is distributed to her. . . .”  2007 WL 3046287, 100 AFTR2d 2007-6379 (9th Cir. 10/18/07) (slip opinion), aff’g per curiam 407 F. Supp.2d 1230 (E.D. Wash. 2005).

The IRS disallowed the marital deduction, asserting that the condition of survivorship caused the residuary bequest to constitute a nondeductible terminable interest under IRC §2056(b)(3). However, the district court concluded that the decedent’s intent was for the residuary bequest to qualify for the marital deduction, citing as authority a Washington statute which requires construction of a marital bequest intended to qualify for the marital deduction in such a manner as to cause it to qualify. The 9th Circuit affirmed per curiam.

To assist a court in construing the will in a manner consistent with the decedent’s intent, the inclusion of the following language might be advisable: “I intend that the value for Federal estate tax purposes of property given, devised or bequeathed outright or in trust to my spouse shall qualify for the marital deduction allowed by Federal estate tax law applicable to my estate.”

The 2nd Circuit, in Estate of Thompson, 499 F.3d 129, 2007 WL 2404434 (8/23/09) vacated a decision of the Tax Court which held that the taxpayer had demonstrated reasonable cause for its understatement. The decedent’s estate valued the decedent’s block of stock at $1.75 million, based upon an appraisal prepared by an attorney and an accountant, which claimed a 40% minority interest discount and a 45% lack of marketability discount. The court noted that the understatement penalty applies automatically, unless it is shown that reliance was reasonable. In this case, the taxpayer had failed to demonstrate that the estate’s reliance on its experts was reasonable and in good faith, or whether the estate knew or should have known that the appraiser lacked the expertise to value the company. This case underscores the importance of ensuring that the appraiser selected is qualified by virtue of a designation from a professional appraisal organization, and has relevant experience in the subject matter of the valuation.

The Tax Court, in Estate of Roski, 128 T.C. 113 (4/12/07) held that the failure of the IRS to exercise discretion with respect to the necessity of requiring an estate to (i) furnish bond equal to twice the estate tax deferred under IRC §6166(a)(1), (ii) provide the IRS with a special lien against estate assets under IRC §6324A, warranted further proceedings. The Tax Court rejected the IRS contention that Section 6166 provided for no judicial review, noting that neither the Code nor the legislative history expressly precluded Tax Court review of IRS discretion in this matter. The estate had attempted without success to obtain a bond and argued that it was barred from pledging business assets because the lien would violate covenants in the partnership agreement.

The use of domestic asset protection trusts has continued to increase, as more states have enacted favorable statutes. Tennessee and Wyoming in 2007 became the eighth and ninth states to permit self-settled trusts. Nevada broke new ground with legislation making it difficult for creditors of persons who own interests in private corporations to satisfy judgments. On July 1st, 2007, Nevada enacted legislation limiting the exclusive remedy for judgment creditors of stockholders in certain corporations to a charging order with respect to the shares in the corporation. Creditors will therefore have no claim against corporate assets, and will be limited to making claims only against actual dividends paid from the corporation. Prior to this statute, this limitation of remedies was available only to LLCs and limited partnerships.

In In Re Eversoff, 2006 U.S. Dist. Lexis 69575 (E.D.N.Y. 9/27/07) the IRS claimed the taxpayer’s transfer of property to an irrevocable trust was fraudulent. Eversoff transferred $220,000 and a house into an irrevocable trust shortly after an IRS audit in which an assessment of $700,000 was issued. Following the transfer, the taxpayer still possessed more than $1 million in other assets, including several retirement accounts.

The IRS argued that the retirement accounts should not be considered in determining the taxpayer’s solvency, and that the transfers rendered the taxpayer insolvent. However, the Eastern District held that under federal law, the IRS could levy on the retirement accounts and seize distributions. Since the taxpayer had sufficient funds to pay the tax assessment even following the transfers in trust, the taxpayer committed no actual or constructive fraud. The court held that the trust assets could not be used to satisfy the tax judgment.

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