2012 Gift & Estate Tax Decisions of Note

View in PDF:  Tax News & Comment — February 2013

2012 Gift & Estate Tax Decisions of Note

I.    Formula Clauses

The Tax Court in Wandry v. Com’r, T.C. Memo 2012-88, nonacq., 2012-46 I.R.B. upheld a defined value clause containing a formula transfer clause. The case is significant since it seemingly vanquished the last vestiges of Proctor v. Com’r, 142 F.2d 824 (4th Cir. 1944) which had invalidated savings clauses as violating public policy, and marks the first time that a court affirmatively sanctioned the use of formula clauses in cases not involving a charitable overflow beneficiary. Some believe that reliance on Wandry may be risky until other Circuits opine. [See Tax Court Defies IRS: Expands Use of Defined Value Clauses, Tax News & Comment, October 2012.]

 II.    Constitutionality of DOMA

 Windsor v. U.S., 833 F.Supp.2d 394 (S.D.N.Y. 6/6/12), aff’d, 2012 WL 4937310 (2nd Cir. 2012), now on appeal to the Supreme Court, held that the Defense of Marriage Act was unconstitutional for purposes of the federal estate tax marital deduction. The Supreme Court may not reach the merits, as the case could be decided on the issue of standing.

 III.   Estate Planning With Family Entities

 Estate of Stone v. Com’r, T.C. Memo 2012-48 held that the management of a family asset consisting of real estate was a legitimate nontax objective in creating  a family partnership.  Therefore, the value of the partnership assets was not includible in the decedent’s gross estate under IRC §2036. The taxpayers in Stone had dotted their “i’s” and crossed their “t’s” by ensuring that they did not transfer so many assets to the partnership such that they would not be able to continue in their accustomed standard of living without the transferred assets. The transferors also avoided personal use of the assets. Interestingly, no discounts whatsoever were taken. Apparently, asset protection (some of the children were about to be married) and a desire to shift future appreciation were the motivations for the transfers.

Similarly, in Estate of Kelly v. Com’r, T.C. Memo 2012-73, the Tax Court held that since legitimate non-tax reasons existed for the transfer of assets into a family partnership, no inclusion would result under IRC §2036. Section 2036 had no application since the decedent had gifted the interests to the partnership and retained no interest whatsoever in the transferred interests. The decedent retained sufficient assets to pay for living expenses, and a bona fide purpose existed for forming the partnership, one of which included asset protection.

When planning with family entities and trusts, the issue frequently arises as to whether gifts qualify for the annual exclusion where the agreement or trust limits the right of the beneficiaries. That issue arose in Estate of Wimmer v. Com’r, T.C. Memo 2012-157 in the context of gifts of limited partnership interests. The Tax Court found that the gifts in question satisfied a three-prong test for qualification as an annual exclusion gift: (i) the partnership had income; (ii) income would flow to the donee; and (iii) income flowing to the donee could be ascertained. An important factor in this case was that distributions were required to be made pro rata.

 IV.    Administration Expenses

 Although it would appear to be permissible to inform an appraiser of the purpose of an appraisal, civil fraud penalties were assessed against the taxpayer in Gaughen v. U.S., __F.Supp.2d__, 109, 109 A.F.T.R.2d 2012-752 (N.D. Pa. 2012) who hired a “Certified General Appraiser” and advised him that he “need[ed] a restricted appraisal report very close to $65,000.” The court denied the taxpayer’s motion for summary judgment, finding that a reasonable jury could find fraudulent intent.

Estate of Gill, T.C. Memo 2012-7 involved the propriety of administration expenses and the marital deduction. Four months before his death, the decedent married a German citizen, who took the name Valerie Gill. Shortly thereafter, the decedent amended the terms of his trust to provide that all income and discretionary payments of principal from a testamentary marital trust would be distributed to Valerie, and that upon her death his children would be trust beneficiaries.

Upon the decedent’s death, his children sued Valerie, alleging undue influence. Eventually the claim was settled, but at a cost of $829,965 in legal fees. The issue was whether the legal fees were deductible by the estate, and whether the marital deduction should be reduced. The court held for the estate on the first issue, finding that the legal fees were necessary to resolve the issue of undue influence.

Resolution of the second issue was more complex. As part of the settlement, the children reimbursed the estate for taxes. The IRS argued that the marital deduction should be reduced since the estate was reimbursed for estate taxes paid as part of the settlement. The Estate argued that the tax burden ultimately fell on the children since they reimbursed the estate. The Tax Court noted that the decedent’s will provided that increases in estate tax would be paid by the person to whom the property was distributed. Since the children who received the property reimbursed the estate for estate taxes previously paid, the children ultimately paid the estate taxes, and therefore the marital deduction did not require reduction.

In Estate of Kahanic v. Com’r, T.C. Memo 2012-81, the decedent had a legal obligation to name his divorced spouse as beneficiary of a life insurance policy on his life. At the time of his death, he had failed to comply with this legal obligation, and payments were made to his estate. Nevertheless, the surviving spouse to whom the obligations were owed received the proceeds of the $2.495 million life insurance policy. The estate reported the value of the life insurance policy and took a corresponding debt deduction. The Tax Court agreed with the estate that under IRC §2053(a)(4), the estate was entitled to take a deduction for the full value of the policy, since the debt was bona fide and was incurred for adequate and full consideration.

V.    Claims for Refund

In Marshall Naify Revocable Trust v. U.S., 672 F.3d 620 (9th Cir. 2/15/12), aff’g 2010 WL 3619813 (N.D. Cal., 2010) the decedent’s estate paid California $26 million on a disputed tax claim. The IRS allowed a $26 million deduction on the decedent’s estate tax return. The estate then filed a claim of refund based on a $47 million deduction, arguing that the higher deduction was appropriate given the likelihood of prevailing in litigation against California, measured at the date of the decedent’s death. The IRS disallowed the refund claim, finding that post-death events were relevant because the amount of the deduction could not be ascertained with reasonable certainty at the date of the decedent’s death.

The District Court agreed with the IRS that since the amount of California’s claim against the estate was not ascertainable with reasonable certainty as of the decedent’s death, under Propstra v. U.S., 680 F.2d 1248 (9th Cir. 1982), it was proper to consider post-death events.

VI.   Intra-family Loans

 In Estate of Lockett v. Com’r, T.C. Memo 2012-123, a limited liability partnership was created. Partnership interests eventually funded a marital trust.  The partnership subsequently made various loans to son of the decedent in amounts ranging from $135,000 to $200,000. The loans were evidenced by properly executed promissory notes and some were repaid. On audit of the estate tax return, the IRS determined that the loans were actually gifts, and asserted a deficiency of $706,110.

Tax Court found that the loans were bona fide since, taking into account the facts and circumstances, a real debtor-creditor relationship existed. However, the Tax Court also found that since the partnership had been dissolved and no gifts of partnership interests had been made to either of two sons, the decedent herself owned all of the assets outright at her death. Accordingly, no discounts were allowed the estate.

 VII.    Gift Tax Returns

 In Dickerson v. Com’r, T.C. Memo 2012-60, a waitress at Waffle House won a lottery worth $10 million, which had a cash payout of $5 million. On the advice of an attorney, Dickerson formed an S Corporation in which other family members owned a 51 percent interest and she a 49 percent interest. The lottery winnings were deposited into the corporation.

Although no gift tax return was filed, the IRS found out about the stock ownership, and asserted a gift tax deficiency alleging that Dickerson had made a taxable gift of 51 percent of the lottery winnings to other family members. The Tax Court agreed with the IRS that a taxable gift had been made, but also accepted the taxpayer’s argument that the gift should be discounted due to ensuing litigation from four other waitresses at Waffle House who claimed an interest in the lottery winnings. Ultimately, the Tax Court settled on a discount of 67 percent, and arrived at total gift of $1.119 million.

 VIII.    Fiduciary Liability

 Being an executor or trustee is not without its risks. The government has a cause of action under The Federal Priority Statute, 31 U.S.C. §3713, where executors or trustees make distributions to which the government had priority. In U.S. v. MacIntyre, 2012 WL 1067283 (S.D. Tex.) the government proceeded under §3713 against a trustee and an executor who had distributed assets in a situation where they had sufficient notice of the government’s claim. Although the amount of assets distributed was very small in relation to the size of the estate, the fiduciaries were held personally liable for an amount of $1.119 million, which had been set aside for a charity.

Although no formal probate may transpire, an estate tax return must nevertheless be filed by the “executor.” In Estate of Gudie v. Com’r, 137 T.C. 165 (2011) the trustee of an inter vivos trust signed the estate tax return as executor. Later, the IRS asserted a substantial deficiency. The trustee argued that since she had not been formally appointed as executor of the estate, the IRS was without jurisdiction to send her a notice of deficiency. The District Court disagreed, finding that a person who is in possession of assets of an estate has an obligation to file an estate tax return, regardless of whether the assets passed through the probate or non-probate estate. Therefore, the executor was a statutory executor under IRC §2203.

 IX.    IRS Power to Issue Summons to States

 It is fairly well known that donors of real estate in which the donees are family members are not always reported on a gift tax return. However, such transfers should be reported for many reasons, not the least of which is that the government will most likely find out about the transfer anyway. Many states, including New York, Connecticut, New Jersey, Pennsylvania, Florida and Texas have provided this information to the IRS. California refused, citing a state statute that prohibits disclosure about personal information. In response, the IRS issued a summons to the California Board of Equalization for the data. The federal District Court denied the summons, finding that the requirements for the issues of a summons under IRC §7609(f) were not met, since the IRS could obtain the data elsewhere.

Following the denial of its petition without prejudice, the IRS served a revised petition, wherein it alleged that it would be unduly burdensome to request the data from each of the 58 counties in California. In response to the revised summons, the District Court found that the IRS had exhausted all administrative remedies, and that California’s sovereign immunity did not preclude the issues of the “John Doe” summons. The court granted the summons.

X.    Abatement of Penalties

In Freeman v. U.S., 2012 WL 26273 (E.D. Pa. 2012), the attorney for the executor failed to file timely estate tax returns, eventuating a penalty. The executor sought remission of the penalties, alleging that the attorney was suffering from physical and emotional ailments, and that the attorney had embezzled from the estate. The executor asserted that reasonable cause existed to annul the penalties. The District Court found for the IRS. Although Reg. §301.6651-1(c)(1) provides that reasonable cause exists where the taxpayer “exercised ordinary business care and prudence and was . . . unable to file the return within the prescribed time . . .”  the Supreme Court in U.S. v. Boyle, 469 U.S. 241 (1985) held that a taxpayer’s duty to timely file a return is nondelegable.

XI.  Liability of “Fiduciary” for Purposes of Estate Tax Return

U.S. v. Johnson, 2012 WL 1898873 (Dist. Ct. Utah 2012), involved the interpretation of IRC §6324(a)(2) which imposes personal liability for unpaid estate taxes upon “transferees” and “beneficiaries.” After the trustee had distributed funds to trust beneficiaries, the estate defaulted on certain estate tax obligations. The IRS argued that the trust beneficiaries were “beneficiaries” for purposes of Section 6324. The defendant beneficiaries motion to dismiss was granted.

The District Court agreed that a “transferee” is a person who receives property immediately after a person’s death, and that transferee liability does not extend to beneficiaries of a trust because a trustee, and not the trust beneficiaries, are in receipt of trust assets at the death of the settlor.

XII.    Protective Refund Claims

 In Davis v. U.S., 2012-1 USTC ¶ 60,634 (N.D. Miss. 2011) the estate paid estate tax based on the belief that the estate owned a fee interest in real property. The estate later learned that it did not own a fee interest, but only a life estate. By the time the (losing) appeals for the estate were exhausted, the estate was time-barred from filing a claim for refund. The estate argued that its due process rights were violated.

The District Court, citing the Supreme Court decision in U.S. v. Brockamp, 519 U.S. 347 (1997) noted that courts may not toll “for non-statutory equitable reasons, the statutory time and related amount limitations for filing tax refund claims set forth in Section 6511 of the . . . Code.” The court noted that the proper course for the estate would have been to file a protective claim. It appears that the existence of the right to file a protective claim was a factor in the court’s finding that no due process violation had occurred.

 XIII.    Attorneys’ Fees

In Estate of Palumbo v. U.S., 675 F.3d 234 (3rd Cir. 2012), a charitable trust and the son of the decedent had a dispute over the amounts to be received by each. Eventually, they settled. The IRS denied the deduction taken by the estate for the amount paid to the charitable trust, on the grounds that the trust had no enforceable claim against the estate. The District Court granted the estate’s motion for summary judgment.

The estate then sought attorney’s fees arguing that the government’s position was not “substantially justified.” The motion for attorneys fees was denied. On appeal to the Third Circuit, the decision to deny attorneys fees was affirmed on procedural grounds. The appeals court never reached the question of whether the government’s position was substantially justified. Instead, the court found that the net worth of the estate exceeded the $2 million threshold for recovery of attorneys fees. The estate argued that the net worth requirement did not apply to 501(c)(3) charitable entitles. Even so, the court held that the attorneys fees could not be granted, since fees can only be awarded to a “prevailing party,” and although the charitable trust would benefit from the award of attorneys fees, it was not a “party” to the litigation.

 XIV.    Conservation Easements

The Code allows an income tax deduction for a qualified donation of a conservation easement. Generally, the deduction is up to 30 percent of the taxpayer’s adjusted gross income. The IRS contested deductions associated with conservation easements in a number of cases in 2012.

In Trout Ranch, LLC v. Com’r, 2012 WL 3518564 (10th Cir. 2012), the taxpayer contributed a conservation easement consisting of water rights, which the taxpayer’s appraiser valued at between $1.59 and $2.3 million. The IRS ascribed a value of zero to the easement. The Tax Court, in a Solomonic manner, rejected both appraisals individually, but arrived at a value of $560,000 using both together.

In Rolf v. Com’r, 668 F.3d 888 (7th Cir. 2012) the taxpayers contributed a lakefront house to the local fire department which intended to burn the house down in training exercises, and claimed a charitable deduction of 76,000 on their income tax return, which was disallowed. The case went to the Court of Appeals, which affirmed the finding of the District Court that the taxpayers had not shown that they did not receive a benefit equal to or exceeding the value of the house. The courts reasoned that since the house was to be burned down immediately, it was of no value. Moreover, it was established at trial that the cost of demolishing the house would have been $10,000 had the taxpayers paid that expense.

XV.    Adequate Disclosure

Treasury regulations are not always a model of clarity with respect to when and whether professional valuations are required when making gifts. Form 8283 at one time stated “If your total art contribution was $20,000 or more you must attach a complete copy of the signed appraisal. Since the taxpayer was not contributing art, he reasoned (incorrectly) by negative implication that no appraisal was required since he was not contributing art.

The Tax Court noted that the result was “harsh” since all deductions would be disallowed, but noted that the statute and regulations comprise the authority for determining whether am appraisal was necessary, and in this case that authority was clear — noncash donations exceeding $5,000 must be supported by a written appraisal completed by an independent qualified appraiser. Mohamed v. Com’r, T.C. Memo 2012-152.

 XVI.    Charitable Contributions

In Durden v. Com’r, T.C. Memo 2012-8, the taxpayer made $25,171 in contributions by check or cash to his church, which donations were supported by evidence consisting of cancelled checks and a letter from the church acknowledging receipt. The IRS disallowed the deduction by reason of the failure of the donee organization to provide a contemporaneous acknowledge and description and good faith estimate of the value of any goods or services provided by the donee organization. Following the disallowance, the taxpayer obtained the required information. However, the IRS still continued to deny the deduction. The Tax Court held for the IRS, citing Reg. §1.170A-13(f)(3) which states that a written acknowledgement is contemporaneous only if it is received on or before the due date of the return for the taxable year of contribution.

 XVII.  Asset Protection Trusts & Federal Income Tax Liability

 The effectiveness of an asset protection trust depends in substantial part on the bona fides of the transaction and of the trust. In U.S. v. Evseroff, 2012 USTC ¶50,328 (E.D.N.Y. 2012), the Eastern District concluded that the asset protection trust created by the taxpayer did not provide any protection against the IRS claim for income tax liabilities. The court found that (i) the trust was not a bona fide entity; that (ii) it had never assumed title to real estate purportedly transferred into the trust; and that (iii) the taxpayer had disregarded the entity by taking deductions attributable to trust property. Accordingly, the transfer constituted a fraudulent conveyance.

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