A.    Issues Arising Under IRC §2036

An important objective in estate tax planning is to transfer of assets out of one’s taxable estate, while retaining a degree of beneficial enjoyment over the transferred property. Where the IRS believes too much beneficial enjoyment had been retained, it may invoke IRC §2036 in an attempt to pull the assets back into the decedent’s taxable estate.
In Estate of Riese, T.C. Memo 2011-60, the decedent continued to live in a residence that had been transferred to a QPRT following the trust term. The Tax Court found that even though no rent was paid by the decedent prior to his death, the executor properly excluded the value of the residence from the gross estate, since the decedent’s daughter was in the midst of preparing a lease agreement when the decedent died suddenly. The contemplated existence of an express agreement calling for rent was sufficient to defeat the application of IRC §2036.
In Estate of Adler, T.C. Memo 2011-28, the decedent years earlier had deeded a one-fifth interest in a 1,100 acre tract of land in Carmel, California to each of his five children, reserving the “full use, control, income and possession” of the property for his life. His estate claimed a 32 percent lack of marketability discount and a 16 percent minority interest discount.
The Tax Court had no problem finding that neither of these discounts was applicable. The retention of enjoyment was express, and IRC §2036(a)(1) clearly applied, since the gift was in effect testamentary. The more difficult question was whether a partition discount was applicable. The court found that it was not: Since Adler had continued to enjoy full use of the property, ownership was not deemed to have been divided until Adler’s death.
In Estate of Van, T.C. Memo, 2011-22, the decedent transferred title to her residence, but continued to reside there without payment of rent. Although some consideration for the residence was paid to her by her children, this was insufficient to defeat the application of IRC §2036. Since nonpayment of rent in this case was a factor in a ruling against the taxpayer, a parent who wishes to continue residing in a residence following its legal transfer should rent pursuant to a lease providing fair rental value. Where ascertaining fair rental value is difficult, engaging a real estate professional to assist in that determination would be advisable.

B.    Step Transaction Doctrine

Another weapon at the disposal of the IRS in attacking discounts taken through family entities is the step transaction doctrine. The step transaction doctrine emphasizes substance over form and may be invoked by the IRS to collapse a multi-step transaction into a single transaction for tax purposes. The doctrine limits the taxpayer’s ability to arrange a series of business transactions to obtain a tax result that would be unavailable if only a single transaction were used. The Supreme Court in Court Holding Company v. Com’r, observed:

To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress. 45-1 USTC ¶9215, 324 U.S. 331, 65 S.Ct. 707 (1945).

In Linton v. U.S., 630 F.3d 1211 (9th Cir. 2011), aff’’g in part, rev’’g in part, and rem’’g 638 F Supp 2d 1277 (D. Wash 2009), the Ninth Circuit reversed the District Court, which had applied the step transaction doctrine. In a meeting with their attorney, the Lintons executed documents transferring real estate and other assets to a limited liability company. At the same meeting, the Lintons signed trust documents giving their children interests in the LLC. The trust documents were undated.
The District Court granted the government’s motion for summary judgment, finding that the gifts to the LLC and the funding of the trusts were in essence simultaneous. Therefore, under the step transaction doctrine, the Lintons had made gifts to their children of the LLC interests. Since the gifts were made before the formation of the LLC, the valuation discounts taken by the Lintons were disallowed.
The Ninth Circuit reversed, finding that the Lintons had merely prepared to make a gift to the trust, but had not actually done so. The court noted that rather than focus on the traditional test for invoking the step transaction doctrine, i.e., whether there was a “binding commitment” to take the later step, the more relevant inquiry was whether the lapse of time between the completion of steps resulted in there being any “real economic risk.”

C.     Partnership Formalities

The failure to follow partnership formalities when engaging in estate planning using family entities is a regrettable lapse, since adherence to formalities is not especially difficult. Four cases decided in 2011 illustrate the pitfalls which taxpayers can encounter if formalities are not observed.
In Estate of Jorgensen, 107 AFTR2d 2011-2069 (9th Cir. 2011), aff’’g T.C. Memo 2009-66, the Ninth Circuit affirmed a decision of the Tax Court finding that the entire value of two partnerships should be included in the estate. The partnership had failed to properly maintain books and records, the decedent had used partnership assets to pay personal expenses and had paid partnership expenses with personal assets.
The Ninth Circuit also found that the Tax Court had not erred in finding an implied agreement that the decedent would be permitted to continue to benefit from partnership assets. The court found that no “legitimate and significant nontax reason” existed for creating the family limited partnership since no special investment skills are required to perpetuate a “buy and hold” investment philosophy.
In Estate of Turner, T.C. Memo 2011-209, the decedent and his wife had made transfers to a family limited partnership but retained sufficient assets outside of the partnership to support themselves. Shortly before the decedent’s death, he made gifts in trust to his children. The IRS found that the exception in IRC §2036(a) for transfers made in exchange for “for adequate and full consideration” was inapplicable. To qualify under the exception, the transfer must have had a “legitimate and significant nontax” purpose. Agreeing with the IRS, the court found that consolidation of assets may underlie a significant nontax purpose, but only where the assets require active management.
In Estate of Liljestrang, T.C. Memo, 2011-259, the decedent transferred various real estate holdings worth about $6 million to a family limited partnership. The decedent transferred limited partnership interests to trusts for his children, but retained all of the general partnership interests.
The Tax Court held that the undiscounted value of the partnership interests were includible in the decedent’s estate under IRC §2036(a), since there no legitimate and significant nontax reason existed for creating the partnership. Although the estate claimed that by transferring the real estate holdings into a trust they would be centrally managed, the Tax Court found that the decedent’s son was already responsible for managing the holdings through an employment agreement in effect with the trust.

D.      Valuation Discounts

With proper planning and execution, the decedent will not have retained interests in the transferred property that would operate to pull the assets back into the gross estate. However, having crossed that threshold, another obstacle remains: The estate may be called upon to justify valuation discounts taken either on filed gift tax returns, or on the estate tax return.
Obtaining an expert appraisal when determining the proper valuation discount is critical in justifying the value of the interest given or sold to a trust. Experts use a variety of methods of determining the proper discounted value. Two such methods are the “cash flow” method and the “asset valuation” method.
The cash flow method involves determining the present value of the discounted cash flow, allowing for any valuation discounts. The asset valuation method determines the total liquidation value of the assets of the entity.
In Estate of Guistina, T.C. Memo 2011-141, the Tax Court determined that the value of the partnership interest in timberlands should be determined using a hybrid of the two valuation methods. The court remarked: “In our view, the cash flow method is appropriate to reflect the value of the partnership if it is operated as a timber company, and the asset method is appropriate to reflect the value of the partnership if the assets are sold. Accordingly, the percentage weight to be accorded the cash flow method should be equal to the probability that the partnership would continue to be operated as a timber company.
The court found that assets of the partnership were worth $150.68 million, and the present value of the discounted cash flow was $51.7 million. Since the business had been in the family for many years, and there was no indication that it would be sold, the court’s finding that the assets of the partnership were three times the cash flow appeared to augur well, since the cash flow method appeared to be the applicable test.
A 25 percent lack of marketability discount was applied to the cash flow method. However, no valuation discount was allowed in determining the asset value of the partnership, since the agreed value of the partnership already took into consideration a marketability discount.
Although the family appeared to have no intention of selling the timberlands, the Tax Court nevertheless ascribed a 25 percent probability to the asset (liquidation) value, and only 75 percent to the discounted cash flow value. In justifying this allocation, the court dryly observed that “people tend to prefer $143 million to $52 million.”.
The result of the hybrid approach of the Tax Court resulted in a deficiency, since the estate had used the discounted cash flow value, assuming that the business would not be sold.  The Tax Court determination concerning the value of the assets resulted in the estate having reported a value which was less than 50 percent of the value determined by the Tax Court. This triggered a 20 percent undervaluation penalty under IRC §6662(a), unless the court found that the reasonable cause exception applied. The court found that the exception did apply: The taxpayer had relied on the lawyer who prepared the estate tax return. The lawyer hired an appraiser. The court found that it was reasonable for the appraiser to assume that the business would not be sold.
It is interesting that in determining the value of the business for estate tax purposes, the Tax Court ascribed a 25 percent probability to the business being sold, but later, in considering whether the undervaluation penalty should be remitted, the court found that the appraiser had been justified in assuming that the business would not be sold after the decedent’s death.
The importance of obtaining a professional appraisal was painfully demonstrated in Estate of Gallagher, T.C. Memo 2011-148. The president and CEO of a closely held newspaper company himself determined the value of the estate’s units in the company at $34.94 million one week after the decedent’’s death. In audit, the IRS asserted the value was $49.5 million. The estate then hired two appraisers, who determined the value of the decedent’s interest as being $26.6 million and $28.2 million.  An expert hired by the IRS ascribed a value of $40.86 million.
Since the value the estate reported on the estate tax return was greater than the value as determined by the estate’s experts, the Tax Court found this to constitute an admission against interest. However, the court noted that it was not bound by the higher amount, noting that “such an admission is not conclusive and the trier of fact is entitled to determine . . . what weight, if any, should be given to the admission.”
Using a discounted cash flow method, the Tax Court ultimately found that the value of the interest was within $1 million of what the taxpayer had reported on the estate tax return. In arriving at its determination, the Tax Court utilized its own discounted cash flow analysis, rather than the analysis posited by the experts for the estate or for the IRS.
In Estate of Levy, 106 AFTR2d 2010-7205 (5th Cir.), aff’’g 2008 WL 5504695 (W.D. Texas 2008), cert. denied, 2011 WL 1481312, the decedent’s estate brought a refund suit after paying a deficiency determined on audit by the IRS.  The Estate claimed that the IRS had valued real property at its rezoned value, whereas at the time of the decedent’s death the change in zoning was highly unlikely.
The Estate also argued that the trial count improperly admitted hearsay evidence. The Fifth Circuit affirmed, finding first that offers from “sophisticated investors” were properly admitted, since the developers could have been called upon to testify at trial. The appeals court dismissed the estate’s rezoning argument, finding that the town’s rezoning plan strongly suggested that the land would be rezoned.
In Estate of Mitchell, T.C. Memo, the IRS challenged the values of two paintings reported on the estate tax return. The estate had valued a Remington at $1.2 million and a Russell at $750,000. The IRS valued the paintings at $2.3 million and $2 million, respectively.  At trial, the IRS Art Advisory Panel determined the values to be substantially less than those reported by the taxpayer.
[The Art Advisory Panel is comprised of a collection of unpaid art experts. The panel reviews audited returns on which an item of art is valued at $20,000 or more, or returns in which the IRS believes that the fair market value exceeds $20,000. To ensure objectivity, the Panel is unaware of whether the appraisal is for estate tax purposes or charitable deduction purposes.]
The IRS asserted that the Art Advisory Panel was unfamiliar with western art, and that its valuations were disparate. However, the Tax Court found that IRS staff appraisals were unreasonably high and accepted the values reported by the estate.

E.   Powers of Appointment

The use of a credit shelter trust can be an effective means of keeping assets transferred to that trust out of both the estate of the decedent and the estate of the decedent’s spouse. Often, the decedent’s spouse is given ample rights with respect to that trust during his or her lifetime. If drafted correctly, those rights given to the surviving spouse should not cause estate tax difficulties in the estate of the surviving spouse. However, if the surviving spouse is a trustee as well as a beneficiary, and the power to distribute principal is too great, the power could be deemed to constitute a general power of appointment under IRC §2041. If so, the entire trust would be included in the estate of the surviving spouse.
Regs. §20.2041-1(c)(2) provides that “[a] power to consume, invade, or appropriate income or corpus, or both, for the benefit of the decedent which is limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent is, by reason of section 2041(b)(1)(A), not a general power of appointment.
In Estate of Chancellor, T.C. Memo, 2011-172, the surviving spouse, who was also a trustee and beneficiary, was given the power to distribute principal “for the necessary maintenance, education, health care, sustenance, welfare or other appropriate expenditures” of the beneficiaries. The IRS argued that the decedent’s power over the trust rose to that of a general power of appointment, and consequently the entire trust should be included in her estate.
The court found that although the right to withdraw for spouse’s ““welfare” may not correlate exactly with the right to withdraw for the “health, education, support, or maintenance,” the inclusion of the word “necessary” indicated that the distribution standard was a function of the decedent’s accustomed standard of living. The Chancellor case illustrates that the inclusion of even one objectionable word in a trust could result in deleterious estate tax consequences. Fortunately, in this case, the trust was held not to have deviated too far from the standards imposed in the Regulations.

F.    Statutes of Limitations

Statutes of limitations can be the bane of both taxpayers and tax professionals. In Dickow v. U.S., 654 F.3d 144 (1st Cir. 2011), the Executor requested an automatic six month extension to file an estate tax return under IRC §6081(a), and then a second automatic extension. Just less than three years later, the Estate filed a claim for refund. The First Circuit upheld an order granting summary judgment to the IRS.
The Executor erred in requesting a second extension, since the Regulations provide that only one six-months extension may be requested. Furthermore, the refund request was not timely since under IRC §6511 to be timely, a refund claim must be made within the later of three years after filing the return or two years of payment of the tax.
The First Circuit found the District Court had properly rejected the taxpayer’’s argument that the IRS should be “equitably estopped” from asserting the statute of limitations, since it had “misrepresented” to him that the second extension requested had been granted by not explicitly rejecting the extension request. The court found that equitable exceptions to the statute of limitations for refund claims under IRC §6511 do not exist. The First Circuit also observed that even if such an exception did exist, the executor had not shown that the IRS had “misrepresented” any fact.
In Baccei v. U.S., 632 F.3d 1140 (9th Cir. 2011), the Executor hired a CPA to prepare an estate tax return. The Form 706 was timely filed, but the CPA failed to complete Part III of the extension, which contained a request for an extension of time in which to pay the tax. Although a letter was appended to the extension request, the District Court found that the request was improper, and that the estate had not established a reasonable cause for the estate’s failure to pay. The Ninth Circuit affirmed. The doctrine of “substantial compliance” was inapplicable; and compliance with the terms of the application for an extension “is essential to the Service’s tax collection efforts.”” The executor’s reliance on a “well-qualified and knowledgeable CPA” failed to constitute reasonable cause for the abatement of penalties.
Although reliance on a tax professional time timely file a return will not operate to justify remission of late-filing penalties, reliance on a tax professional as to a substantive tax issue may constitute reasonable cause and justify the abatement of penalties. Such was the case in Estate of Liftin v. U.S., USTC ¶60,630 (Fed. Cl., Nov. 8, 2011).
In Liftin, the decedent’s widow was in the midst of applying for citizenship, which would allow the estate to take a full marital deduction. The executor hired an estate planning attorney, who advised that filing the estate tax return after the due date would not trigger a penalty provided the return was filed within a “reasonable time” after the widow became a U.S. citizen. Although the advice was incorrect, the Court of Claims found that reasonable cause may exist where the taxpayer relies on an expert’s erroneous advice. The court denied the government’s request for summary judgment.

G.     Formula Clauses

When structuring sales to grantor trusts for estate planning purposes, use is often made of formula clauses, which operate to redistribute interests in the event of a successful IRS challenge to the asserted value of assets sold or transferred to the trust. These changes could occur either because the IRS claims that the value of the asset was higher than reported, or that the valuation discount taken was excessive.
In Estate of Petter, 653 F.3d 1012 (9th Circuit), aff’’g T.C. Memo 2009-280, Petter, an heir to the founder of UPS, made gifts to grantor trusts equal to “one-half the minimum dollar amount that can pass free of federal gift tax by reason of the Transferor’s applicable exclusion amount.” The trust indenture provided that if the amount finally determined for federal gift tax purposes exceeded the amount described in the trust instrument, the excess would be transferred to a charitable foundation.
On audit, the IRS found the formula clause unenforceable, as it violated public policy. However, the Tax Court found that the gifts of an “ascertainable dollar value of stock” defined by formula were valid. The charitable beneficiaries were also represented by independent counsel, were not subservient to the taxpayer, and were not motivated by a desire to reduce the tax liability of the donor. The Ninth Circuit affirmed.
The Tax Court also approved the formula clause in Hendrix v. Com’r, T.C. Memo, 2011-133. In Hendrix, a formula clause was employed to determine the number of shares of closely held Subchapter S stock to be transferred to trusts, and the number of shares that would be transferred to a charitable foundation. The Tax Court approved the use of the formula clause to determine the amount of stock transferred. The stock was difficult to value, and the court found no evidence of collusion. The court noted that the formula clause also furthered the public policy of encouraging charitable gifts.

H.    Annual Exclusion Gifts

Use of the annual exclusion to cover gifts made to an irrevocable life insurance trust (ILIT) is important in leveraging the gift tax exclusion. The right of beneficiaries to withdraw an amount equal to the annual exclusion renders those transfers gifts of a present interest. Crummey letters (named after the case) are ordinarily sent to beneficiaries on an annual basis, advising the beneficiaries of their right of withdrawal.
In Estate of Turner, T.C. Memo 2011-209, the taxpayer established an ILIT for the benefit of his children and grandchildren. Upon the death of the taxpayer, the IRS denied the annual exclusion, asserting that Crummey letters were not always sent. However, the Tax Court found that the right of the beneficiaries to withdraw amounts from the ILIT created a present interest. The fact that some of the beneficiaries may have been unaware of their right to withdraw was immaterial, since it did not prevent the creation of a present interest. The court noted that in the Crummey case itself, notice was not given.

I.    IRS Subpoenas

Placing a family member on a deed to real property may be done for a variety of reasons, but whatever the reason, the transaction will generally result in a taxable gift. Nevertheless, taxpayers sometimes fail to file gift tax returns reporting the transfer. While some earlier case law found that there could be an absence of donative intent and, ergo, no taxable gift, where the donor made the transfer to avoid probate, the authority for this proposition is not compelling.
Recognizing this situation, the IRS petitioned the District Court in California to issue a summons to the California Board of Equalization requesting that the Board furnish the IRS with its database in order to determine donors who had failed to file a gift tax return. Under California law, transfers between parents, children and grandparents cannot be subject to reassessment. The District Court rejected the IRS request, finding that the information was available through other means. In dicta, the court also questioned whether a “John Doe” summons could be issued to a sovereign state.

J.   Acknowledgement of
Charitable Gifts

IRC §170(f)(8)(A) requires, as a condition to taking a charitable deduction, that the charity provide the taxpayer with a contemporaneous written acknowledgment. In Bruce v. Com’r, T.C. Memo 2011-153, the taxpayer reached a settlement agreement with his county concerning a driveway easement. The county furnished the taxpayer with a letter of acknowledgment, but the IRS found that the letter did not satisfy IRC §170. The Tax Court agreed with the IRS, and disallowed the taxpayer’s $1.87 million deduction. The court found that the acknowledgment was not contemporaneous since the rights and obligations created under the agreement were conditioned upon the county obtaining approval for the settlement.