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I.    Valuation Discounts

In Estate of Litchfield, T.C. Memo 2009-21, the Tax Court generally approved the lack of control (14.8%), lack of marketability (36%), and built-in capital gains (17.4%) discounts for minority interests in closely-held S corporation stock owned by the decedent at his death. In reaching its holding, the Tax Court emphasized that while the taxpayer’s appraiser had interviewed corporate officers, the IRS appraiser relied solely on outside data.

In Estate of Hester, 99 AFTR 2d 2007-1288, aff’d per curiam, 102 AFTR 2d 2008-6716, cert. denied sub nom., 128 S.Ct. 2168 (2009), the decedent breached his fiduciary obligations with respect to a trust created at the death of his wife by transferring all of the trust assets into his own name. He then pledged the distributed trust assets as security for margin loans, withdrew over $450,000 in cash, and collected $280,000 from a promissory note held by his late wife’s estate. Despite this misappropriation of funds, no one appeared at a “debt and demands” hearing to oppose the distribution of assets pursuant to his will.

The decedent’s estate paid $2.727 million in estate taxes, and made a claim for refund, which was denied by the IRS. The court ruled that since no claim was made against the estate and none was “reasonably expected,” the estate was not entitled to a deduction under §2053(a)(3) as a claim against the estate, or under §2053(a)(4) as a debt of the decedent.

Note: The Estate chose to pay the tax and then file a claim for refund in the Virginia District Court, rather than proceed to Tax Court, where the deficiency may be litigated before any obligation to pay arises. This strategy, as will be seen below, has been successful in a number of cases.

A divided Tax Court, in Pierre v. Com’r., 133 T.C. No. 2 (2009) held that a single member LLC, though ignored for income tax purposes, must be respected as a separate entity for gift and estate tax valuation discount purposes. The IRS was unsuccessful arguing that the election under the “check-the-box” regulations to treat the entity as being disregarded for tax purposes should also result in its being disregarded for gift and estate tax valuation discount purposes. The case illustrates the danger of using single member LLCs — or any disregarded tax entity such as a single-shareholder S corporation — if the objective is to validate estate or gift tax valuation discounts.

The Ninth Circuit, in Stone v. U.S., 103 AFTR2d 20091379, affirmed a decision of the Tax Court limiting the estate’s discount to a collection of valuable artwork to 5%. The IRS was successful in limiting the lack of marketability discount to the costs of a partition action.

II.     IRC § 2036 Inclusion

IRC Section 2036 continued to play a decisive role in many decisions involving valuation discounts.

¶  In Estate of Hurford, T.C. Memo 2008-278, the Tax Court disallowed all discounts, and included the undiscounted value of the underlying assets in the decedent’s estate. The case had bad facts. Employment agreements with children were never executed, stock certificates, regulations, and organizational minutes of LLCs were unsigned, FLP operation was sloppy, assets of marital trusts were withdrawn to fund FLPs in violation of trust provisions, and the surviving spouse, who had sole check-writing authority over the FLP accounts, transferrred money without regard to the interests of the partners and without recording the transactions.

¶    The IRS was also victorious in Estate of Jorgensen, T.C. Memo 2009-66. Col. and Ms. Jorgensen funded a Virginia limited partnership with marketable securities. Their children were named as general partners even though they made no contributions to the partnership. The Tax Court held that the transfer to the partnerships was not a bona fide sale for adequate and full consideration so as to come within the exception under IRC § 2036(a), since there was no “legitimate and significant nontax reason for creating the family limited partnership.”

¶  In Estate of Miller, T.C. Memo 2009-66, the decedent created an FLP and gifted interests to her children. The FLP hired a corporation managed by her son to manage investments. At her death the estate claimed a 35% discount for FLP interests held in trust. The Tax Court held that securities transferred in 2002 were not includible in the decedent’s gross estate, and approved the discount for lack of marketability. However, later transfers made when the decedent was in declining health were found to be includible in the gross estate since they were not made with a “legitimate and substantial nontax purpose.”

¶  In Estate of Keller, 104 AFTR 2d 2009-6015 (S.D. Tex.), the decedent, who had been ill, signed various documents organizing LLCs before her death. Some organizing documents contained blanks because of uncertainty about fair market values. The decedent died before accounts were opened and the LLCs were formally funded. Believing that the LLCs had not been properly formed, the estate took no discounts and paid estate taxes of $147.8 million.

Thereafter, the decedent’s son learned of the decision in Church v. U.S. 85 AFTR 2d 2000-804 (W.D. Tex. 2000), which had allowed valuation discounts for an unfinished family partnership. The estate filed a claim for refund, which the IRS denied. Holding for the estate and allowing the discounts, the District Court in Texas found that the decedent intended to fund a valid Texas LLC whose purpose to protect family assets. Since any estate tax savings which accrued were merely incidental, the transfers were found to be for full and adequate consideration.

¶  In Estate of Malkin, T.C. Memo 2009-212, the decedent created an FLP and assigned to it stock of a company in which he was the CEO. The FLP interests were then sold to trusts for a self-cancelling installment note. The assets were later pledged to secure a bank debt. The Tax Court held that since the stock was used to secure a personal debt, the decedent retained the right to beneficial enjoyment of the stock, resulting in inclusion in his gross estate under IRC 2036(a).

¶   In Estate of Murphy, 2009 WL 3366099 (W.D. Ark.), transfers were made to limited partnerships, and discounts were taken for lack of control and lack of marketability. The District Court held that the value of the partnership interests retained by the decedent should reflect a 41% discount for lack of control and lack of marketability. The court rejected the IRS argument that the transfer was without consideration, noting that a bona fide sale occurs where a transfer is made in good faith with “some potential benefit other than the potential estate tax advantages that might result from holding assets in partnership form.”

III.    Annual Exclusion Gifts

In Barnett v. U.S., 104 AFTR 2d 2009-5143 (W.D. Pa.), the decedent executed a durable power of attorney in favor of his son, who then made 17 annual exclusion gifts. Twelve of the checks were given before the decedent’s death, but were cashed after his death. The power of attorney did not contain an express authorization to make gifts. The District Court agreed with the IRS that all of the checks written by the son were includible in the decedent’s estate since the son lacked authority to make gifts.

[Note: Under NY General Obligations Law §5-1501, which became effective on 9/1/09, a power of appointment may contain a “Statutory Major Gifts Rider.” This rider, which must be executed simultaneously with the power of attorney itself, authorizes the agent to make gifts. The individual executing the power may (but need not) also authorize the agent to make gifts to the agent himself.]

IV.     Estate Tax Deductions

In Estate of Williams, T.C. Memo 2009-5, the decedent left interests in a Coca Cola bottling plant to four charities and to the children of her father’s business partner. Litigation between the charities and the estate resulted in the each charities receiving an additional $6 million. The IRS initially issued a deficiency, arguing that the estate had undervalued the stock. After the IRS abandoned this argument, the estate sought a refund based on the additional $24 million in charitable distributions. The IRS denied the refund, reasoning that any increase in the charitable deduction was offset by an increase in the value of the gross estate. The estate argued, and the Tax Court agreed, that the shares were not part of the decedent’s estate since the stock had been constructively sold years earlier.

In Estate of Miller, T.C. Memo 2009-119, a QTIP trust had been created for the benefit of the surviving spouse. However, no income was ever distributed to the surviving spouse, and the trust reported income on its own fiduciary income tax return. Upon the death of the surviving spouse, her estate argued that trust assets should not be included in her gross estate since she had never received income from it. [IRC §2044(a) includes in a decedent’s gross estate the value of any property in which the decedent had a qualifying income interest for life.] The Tax Court held for the IRS, stating that §2044(a) applies to any property for which a deduction was allowed under §2056(b)(7).

In Estate of Charania, 133 T.C. No. 7 (2009), the decedent resided in Belgium at the time of his death. At that time, he owned 250,000 shares of Citigroup, Inc., which would be considered U.S. property for estate tax purposes. The decedent and his wife were both born in Uganda and were citizens of the United Kingdom.  The estate claimed that only one-half of the stock was includible in the decedent’s gross estate, because the shares were community property under Belgian law.

In a case of first impression, the Tax Court, applying English law and English conflicts-of-law rules, held that the stock was not community property, since (i) under the principle of “immutability,” propery acquired after a change in domicile is subject to the regime established before the change in domicile; and (ii) although Belgian law contains a provision that would have allowed the decedent and his spouse to change the marital property regime, the couple did not avail themselves of that election.

V.     Waiver of Penalties

In Estate of Lee, T.C. Memo 2009-84, relying on an attorney’s professional advice, the estate claimed a marital deduction for a spouse who had actually died 46 days before the decedent. The rationale for taking the marital deduction stemmed from the naïve belief that a provision in the predeceasing spouse’s will which provided that anyone who did not survive the testator by six months would be deemed to have predeceased the testator, justified the federal estate tax deduction.

Although the predeceasing spouse provision would be valid as against other takers under the will, the Tax Court articulated that that a will cannot presume survivorship sufficient to satisfy the marital deduction requirements (except where it is not possible to determine factually which spouse survived). Nevertheless, court chose to abate the accuracy-related penalties, stating that reliance on a tax professional may be justified if, under all the facts and circumstances, the reliance is reasonable and the taxpayer acted in good faith.

However, the Estate of Fuertes was not so fortunate with respect to the waiver of penalties. 2009 WL 3028823 (N.D. Tex. 2009). Twenty-seven days after the due date of the estate tax return, the attorney applied for an extension and made a tax payment of $2.2 million. The IRS denied the extension and imposed late filing and late payment penalties totaling $554,958.28. The court granted the IRS motion for summary judgment, noting that the taxpayer must show that the failure did not result from willful neglect. Reasonable cause does not exist where the taxpayer relies on a tax attorney to timely file a return, since that does not constitute reliance on the legal advice of a professional.

VI.       Executor Liability

In U.S. v. Guyton, Jr., 103 AFTR 2d 2009-2112, the District Court held the executor liable for unpaid taxes relating to gain from the sale of a chicken farm which was reported on the decedent’s final income tax return. Although the taxes for which the executor was held liable related to an interest which passed outside of the probate estate, the court reasoned that state law provided an adequate remedy between the executor and his brother, who had entered into a written agreement concerning the payment of taxes. Moreover, since the IRS was not a party to that agreement, it could not be bound by its terms.

VII.      Formula Disclaimers

The Eighth Circuit, in Estate of Christiansen, approved the use of formula disclaimers. __F.3d__, No. 08-3844, (11/13/09); 2009 WL 3789908, aff’g 130 T.C. 1 (2008). Helen Christiansen left her entire estate to her daughter, Christine, with a gift over to a charity to the extent Christine disclaimed her legacy. By reason of the difficulty in valuing limited partnership interests, Christine disclaimed that portion of the estate that exceeded $6.35 million, as finally determined for estate tax purposes.

Following IRS examination, the estate agreed to a higher value for the partnership interests. However, by reason of the disclaimer, this adjustment simply resulted in more property passing to the charity, with no increase in estate tax liability. The IRS objected to the formula disclaimer on public policy grounds, stating that fractional disclaimers provide a disincentive to audit. The Eighth Circuit, in upholding the validity of the disclaimer, lectured the IRS, remarking that “we note that the Commissioner’s role is not merely to maximize tax receipts and conduct litigation based on a calculus as to which cases will result in the greatest collection. Rather, the Commissioner’s role is to enforce the tax laws.”

Although “savings clauses” had since Com’r. v. Procter, 142 F.2d 824 (4th Cir.), cert. denied, 323 U.S. 756 (1944), rev’g and rem’g 2 TCM [CCH] 429 (1943) been held in extreme judicial disfavor on public policy grounds, carefully drawn defined value formula clauses have seen a remarkable rehabilitation. So much so that the Tax Court in Christiansen concluded that it “did not find it necessary to consider Procter, since the formula in question involved only the parties’ current estimates of value, and not values finally determined for gift or estate tax purposes.”