ABA Section of Real Property, Trust and Estate Law’s 30th Annual Spring Symposia CLE Meeting
May 10, 2018
Estate of Sommers v. Commissioner, 149 T.C. No. 8 (August 22, 2017)
CCA 201745012 (Nov. 9, 2017)
PLRs 201730012, 201730017, and 201730018 (July 28, 2017)
Ryan A. Walsh
Hamilton Thies & Lorch LLP
200 South Wacker Drive, Suite 3800
Chicago, Illinois 60606
Estate of Sommers v. Commissioner, 149 T.C. No. 8 (August 22, 2017)
Are you sure your net gift is not a net net gift? Should it be?
The Sommers was a case involving a “net gift” transaction, which nearly became a net net gift due to operation of state estate tax apportionment law. The case also involved the taxpayer’s argument that the gift tax paid was deductible on the federal estate tax return, and two distinct marital deduction issues, one of which related to the inclusion in the gross estate under § 2035 of the gift tax paid when the decedent died within three years of making the gift.
In 2001, the decedent (who was then divorced from the wife he later re-married) sought legal advice on how to transfer works from his art collection to his three nieces, who were then his closest living relatives. His attorneys offered two proposals to reduce or eliminate gift tax on the gift of the artwork. First, they recommended that decedent transfer the artwork to a newly formed limited liability company and then make gifts of the units representing ownership interests in the entity to the nieces. This recommendation assumed that, as a result of applicable valuation discounts, the appraised value of the units in the limited liability company would be less than the value of the artwork they represented. The attorneys also recommended that the decedent make the intended gifts in two stages, transferring some units to each niece on or before December 31, 2001, and the rest thereafter. Spreading the gifts across the end of the year would increase the portions of the gifts that could be covered by the gift tax annual exclusion and also allow the decedent to use the increased applicable exclusion amount of $1,000,000 that was scheduled to take effect in 2002. Decedent wanted to transfer the maximum number of units possible to the nieces without incurring gift tax in 2001 and then complete the gifts of the units in 2002.
In accordance with the plan, decedent transferred the artwork to Sommers Art Investors, LLC and executed two sets of gift and acceptance agreements with his nieces, the first dated December 27, 2001 and the second dated January 4, 2002. When decedent and his nieces initially executed the agreements, they left blanks for the number of units for each transfer, pending completion of an appraisal of the artwork. The appraisal, completed in March 2002, assigned a value to the artwork that led decedent’s attorneys to conclude that dividing the transfers of the units between 2001 and 2002 would not allow for the complete avoidance of gift tax.
After the nieces agreed to pay any gift tax resulting from the 2002 transfers, the gift and acceptance agreements were completed by filling in the blanks for the numbered units covered by each transfer. Decedent and his nieces amended each of the 2002 agreements to add a provision in which each donee-niece “agreed to pay the gift taxes, if any, relating to the gift of the units, including, without limitation, any gift taxes, penalties, and interest that may later correctly be assessed.” None of the 2002 agreements referred to apportionment of any federal estate tax liability resulting from the gifts, but none of them specifically exculpated the donees from other liabilities.
In June 2002, shortly before remarrying his ex-wife, decedent initiated litigation in Indiana against his nieces challenging the validity of the purported gifts and seeking return of the artwork. The litigation in Indiana and similar litigation initiated by his wife in New Jersey after decedent’s death on November 1, 2002 ultimately upheld the validity of the gifts.
In an earlier case, Estate of Sommers v. Commissioner, T.C. Memo. 2013-8 (January 10, 2013), the Tax Court also upheld the validity of the gifts. The surviving spouse had initiated that case as well, seeking a ruling that the gifts were not valid; therefore the inclusion of the artwork in the decedent’s gross estate would result in the entire estate due on them being apportioned to the nieces under the New Jersey estate tax apportionment statute. The Tax Court ruled that the gifts were completed, but denied the motion for summary judgment on the estate tax apportionment issue, stating that the parties at that stage had not adequately briefed the issue. After the ruling in the prior Sommers case, the parties stipulated that the 2002 gift tax liability for the second tranche of LLC transfers to the nieces was $273,990. After the entry of that stipulation, in accordance with the agreements governing their gifts from decedent, the three nieces paid the gift tax due on the 2002 gifts.
In April 2002, decedent executed his will that directed his executor “to pay all of … [his] just debts … including funeral and burial costs, and expenses of … [his] last illness, and all costs and expenses of administering and settling … [his] estate.” The will gave everything left after payment of those debts to decedent’s surviving spouse. This provision in the will did not mention taxes.
Decedent died in November 2002. Decedent’s wife succeeded to the property she owned jointly with decedent, received other property pursuant to beneficiary designations, and would have received all assets remaining in decedent’s estate remaining after the payment of debts and expenses.
On the decedent’s federal estate tax return, the executor (the surviving spouse) included assets totaling $1,734,476.29 that were either held in joint tenancy or tenancy by the entireties with the surviving spouse, or given to the surviving spouse directly through beneficiary designations. The estate also included “other miscellaneous property” of $59,494 and “lifetime transfers” of $507.34. The estate tax return included a potential claim of $200,000 against a trust of which the decedent was a beneficiary and co-trustee, and the artwork which had been given to the nieces. On the return, the decedent’s estate took deductions for legal and accounting fees, other administration expenses, and debts of $413,459.86, and a marital deduction of $3,330,510.43. All of this left the decedent with a taxable estate, as reflected on the return, of $507.34:
The IRS, upon examination, but before the stipulation was entered in the prior Sommers decision on the gift tax liability, made three adjustments that increased decedent’s taxable estate from $507.34 to $1,092,106.68 and resulted in estate tax due of $542,593.34: it included under 2035(b) its original assessment of gift tax due in the amount of $510,648; excluded from the gross estate the $1,750,000 value of the artwork included on the return; and reduced the allowable marital deduction by $2,330,951.34. The reduction in the marital deduction (by more than the $1,750,000 removed from the gross estate) reflected the IRS determination that the estate tax due on the 2035(b) inclusion of the gift tax due would have to be paid out of marital assets.
The IRS, after the stipulation as to the amount of gift tax owed on the 2002 gifts in the prior Sommers case, determined estate tax of $220,726 on a taxable estate of $494,716.65. The $200,000 potential claim listed on the original return was removed from the gross estate, and the deduction allowed for decedent’s debts was increased by $105,928.35 (the interest on the gift tax liability). The estate tax deficiency of $220,726 reduced the marital deduction that the IRS would allow to $1,054,362.77. Thus, when this second Sommers case went to the Tax Court, the estate was as follows:
The estate filed three motions for partial summary judgement seeking determinations that:
- The gift tax owed at decedent’s death on his gifts to nieces was deductible under Section 2053;
- The estate was entitled to a marital deduction equal to the value of decedent’s non probate property that the wife received or to which she succeeded that, under applicable state law, was exempt from decedent’s debts and the expenses of the estate; and
- Any federal estate tax due must be apportioned to the nieces and thus did not reduce the estate’s marital deduction.
The three nieces filed their own motion for partial summary judgment that none of the estate tax liability could be apportioned to them. The nieces supported the estate’s first two motions. The IRS objected to the estate’s first two motions but supported the third motion (that federal estate taxes should be apportioned to the nieces). Thus, both the estate and the IRS opposed the niece’s motion for summary judgment.
Deduction for Gift Taxes Paid After Death
The estate moved for summary judgment that the gift tax owed at decedent’s death on his gifts to nieces was deductible under Section 2053. Treas. Reg. § 20.2053-6(d) provides that “[u]npaid gift taxes on gifts made by a decedent before his death are deductible.” The decedent’s estate argued that the plain terms of that provision allowed a deduction for the gift tax owed on the 2002 gifts and unpaid at his death.
When a net gift is made, the full value of the property transferred by the donor to the donee is not treated as a taxable gift. Instead, the taxable gift, determined algebraically, is the difference between the total value of the property transferred and the gift tax on the “net” gift. Despite the allowance of a deduction for gift taxes “unpaid” as of the decedent’s death under Treas. Reg. § 20.2053-6(d), the court found that the “key question” was not whether the decedent or his estate served as the ultimate source of funds for the gift tax, but when the decedent parted with the value.
Here, decedent effectively provided the nieces with the wherewithal to pay tax on the taxable gifts because for each niece, a portion of the units transferred in 2002 was ultimately determined to be a taxable gift, while another portion was determined to be the value necessary to pay the gift tax with respect to the net gift. Therefore, because the decedent made the transfers to the nieces before he died, he reduced his gross estate by not only the value of the taxable gifts but also the by the amount of the tax on the gifts.
In addition, the court noted that longstanding precedent established that a claim against an estate is deductible in computing the estate tax liability only to the extent that it exceeds any right to reimbursement to which its payment would give rise, and that this principal required denying to the estate any deduction for the gift tax owed at the decedent’s death on his 2002 gifts to his nieces. Even if the estate had paid the gift tax after the decedent’s death, it would have had a right to reimbursement from the nieces pursuant to the net gift agreements.
The court wrote that the “gross-up” rule of § 2035 was included in the Tax Reform Act of 1976 to “deter taxpayers from making gifts shortly before death to exclude from their estate (and avoid transfer tax on) the property used to pay the transfer tax.” The court found that allowing a deduction in this case would allow the excess of the “gross transfer” over the “net gifts” to escape transfer tax altogether. Inclusion of the gift tax in decedent’s estate did not justify allowing a deduction for gift tax paid in this case any more than in a case of a gross gift for which the decedent paid the gift tax before the decedent died. Indeed, the estate “acknowledge[d] that the deduction [it sought] would neutralize the impact of section 2035(b).”
For example, if a gross gift of $7,142,858 is made, the gift tax liability would be $2,857,142. If the donor dies within three years of making the gift but had paid the gift tax prior to death, that amount would have be removed from the gross estate, no deduction would be allowed under Treas. Reg. § 20.2053- 6(d), and the estate would include the $2,857,142 gift tax liability in the gross estate under § 2053(b).
However, if the gift tax was not in fact paid by the donor prior to his or her death, the gift tax of $2,857,142 would be included in the gross estate under § 2053(b), and that amount would also remain in the donor’s gross estate. In that case, the deduction allowable under Treas. Reg. § 20.2053-6(d) for the gift tax paid after death is appropriate to avoid double-counting the amount of the gift tax.
If a net gift (a “gross transfer”) of $10,000,000 is made, the donor has “withdraw[n] from his potential estate not only the value of the taxable gifts but also the amount of the tax on the gifts.” Even if the gift tax is paid after the donor’s death (by the donees), no deduction is allowed. The gift tax liability of $2,857,142 is included in the estate only once, under § 2053(b).
Marital Deduction Reduced Due to Payment of Debts and Expenses
The court also denied the estate’s motion for partial summary judgment regarding the effect of the payment of debts and claims on the marital deduction because the amount of the allowable deduction turned on the factual question of the extent to which assets otherwise exempt from claims against the estate were used to pay estate debts and expenses, and when those debts and expenses were paid.
Section 2056(a) allows a deduction for the “value of any interest in property which passes or has passed from the decedent to the surviving spouse.” Treas. Reg. § 20.2056(b)-4(a) provides that value for that purpose means net value. Consequently, when property that would otherwise have been distributed to surviving spouse is used to satisfy debts of the estate, it is not included in the allowable marital deduction. The court stated, “[e]ven when marital assets would otherwise be exempt from debts and expenses under State law or the terms of the decedent’s will, executors may be forced to sell those assets to satisfy debts and or pay expenses if nonmarital assets are insufficient.” In addition, “[f]or purposes of determining the marital deduction, the value of the marital share shall be reduced by the amount of the estate transmission expenses paid from the marital share.” Treas. Reg. § 20.2056- 4(d)(1)(ii).
The deduction allowed to an estate under section 2053(a) for expenses and claims generally cannot “exceed the value, at the time of the decedent’s death, of property subject to claims,” but claims and expenses paid from property not subject to claims are nonetheless deductible if they are paid before the due date of the estate tax return. § 2053(c)(2). Note that if expenses are incurred in administering the property not subject to claims, those expenses are deductible so long as they are paid before the expiration of the period of limitation for assessment of the estate tax return. § 2053(b).
As described above, the assets of the estate other than assets passing directly to the surviving spouse as surviving joint tenant or by beneficiary designation totaled $59,494.00. However, the estate claimed deductions on the estate tax return of $413,459.86 for fees, expenses, and debts.
The court wrote that the “excess” amount of debts and expenses “would be fully deductible only if [they] were voluntarily paid before the due date of the estate tax return out of assets that were exempt from claims against the estate.” Although not specifically stated, the court must have been operating
under the belief that none of the expenses were “incurred in administering property not subject to claims.” See § 2053(b). The court held that either the allowable marital deduction must be reduced by the amount of the decedent’s fees, expenses, and debts paid from property otherwise passing to the surviving spouse, or the estate is not entitled to deduct in full the debts and expenses reported on the estate tax return. The factual questions of the extent to which assets otherwise exempt were used to pay debts and expenses and when they were paid precluded the court’s re-determination of the actual amount of the allowable marital deduction.
Marital Deduction Reduced by Estate Tax Incurred on Gift Tax Inclusion
On the question of whether the federal estate tax due reduced the estate’s marital deduction, the court devoted over eleven pages of this Tax Court opinion to state law on estate tax apportionment. This case turned on interpretation of the New Jersey estate tax apportionment statute, the relevant parts of which provide as follows:
Whenever a fiduciary has paid or may be required to pay an estate tax under any law of the State of New Jersey or of the United States upon or with respect to any property required to be included in the gross tax estate of a decedent under the provisions of any law, hereinafter called “the tax,” the amount of the tax … shall be apportioned among the fiduciary and each of the transferees interested in the gross tax estate…, and the transferees shall each contribute to the tax the amounts apportioned against them. N.J.S.A. 3B:24-2.
“Gross tax estate” means all property of every description required to be included in computing the tax. N.J.S.A. 3B:24-1.b.
“Transferee” means any person to whom the gross tax estate or any part thereof is, or may be, transferred or to whom any benefit therein accrues other than that part of the gross tax estate which passes under the will of decedent…. N.J.S.A. 3B:24-1.c.
That part of the tax shall be apportioned to each of the transferees as bears the same ratio to the total tax as the ratio which each of the transferees' property included in the gross tax estate bears to the total property entering into the net estate for purposes of that tax…. N.J.S.A. 3B:24-4.a.
Any deduction allowed under the law imposing the tax by reason of the relationship of any transferee to the decedent or by reason of the charitable purposes of the gift shall inure to the benefit of the fiduciary or transferee, as the case may be…. N.J.S.A. 3B:24-4.b.
The court noted that the New Jersey estate tax apportionment statute was enacted in 1950, and “did not explicitly address the possibility that the value of property not includible in the decedent's gross estate could nonetheless influence the amount of estate tax liability. When those statutes were first enacted, that possibility did not arise, at least under the Federal estate tax law.” Prior to 1976, “lifetime gifts made by a decedent could affect his Federal estate tax liability only if made in contemplation of death, in which case the transferred property was included in the decedent's gross estate.” The court wrote that “[t]he New Jersey courts have yet to address the extent to which their State’s statute provides for apportionment of estate tax to recipients of lifetime gifts.”
The estate argued that the decedent’s gifts were part of his “gross tax estate” within the meaning of the New Jersey apportionment statute. The estate also argued that a portion of the property the nieces received “represent[ed] the gift tax that was added back to [decedent's] estate.”
The IRS agreed that “the estate tax is apportioned to [the nieces] under New Jersey law, [so that] the estate tax does not reduce the marital share.” The IRS reasoned that the nieces were “transferees” within the meaning of the New Jersey statute, because they “are persons to whom a benefit in the gross tax estate accrues.”
The nieces argued that “Gift Tax Clawbacks are not ‘transferees’ propery’ [sic] within the meaning of the Apportionment Statute,” and that apportioning any of the estate tax liability to them would be inconsistent with decedent’s intent. The intent, they argued, was displayed in the net gift agreement, under which the only liability the nieces agreed to bear was the gift tax.
The court found that under the New Jersey’s estate tax apportionment statute, no portion of any estate tax could be apportioned to the three nieces. Even though the definition of “gross tax estate” means all property “required to be included in computing the tax,” the court explained that “both the structure of the apportionment scheme as a whole and the history of the specific provision defining ‘gross tax estate’ suggest that the New Jersey legislature intended the phrase ‘included in’ to limit the gross tax estate to property encompassed within the base to which the tax applies.” Further, “[a]lthough adjusted taxable gifts, together with the taxable estate, form the base on which the ‘tentative tax’ provided for in sec. 2001(b)(1) is computed, that tax is reduced by a hypothetical tax on post-1976 gifts. The inclusion of adjusted taxable gifts in the base to which the tentative tax applies thus serves only to push the taxable estate further up the marginal rate scale.”
Because the LLC units the nieces received from their uncle were not included in computing the decedent’s federal estate tax liability under the New Jersey apportionment statute, the nieces were not “transferees” against whom any of the estate tax liability could be apportioned for purposes of the New Jersey apportionment statute.
In addressing the estate’s second argument, which rested on “the unique circumstances of a ‘net’ gift,” the court found that “no portion of the units decedent transferred to [the nieces] was included, as such, in his gross estate.” While the general rules provide that the gross estate includes “the value of specified items of property,” section 2035(b) “speaks instead of amounts: ‘The amount of the gross estate (determined without regard to this subsection) shall be increased by the amount of any tax paid … on any gift made by the decedent … during the 3-year period ending on the date of the decedent’s death.’” Thus, the nieces were not persons “to whom the gross tax estate, or any part thereof” was “transferred,” and thus were not “transferees” within the meaning of the New Jersey statute.
The court went on to discuss whether the payment of the estate tax would reduce the marital deduction claimed by the estate, with respect to which the estate had argued, “New Jersey law does not permit apportionment of the tax to a surviving spouse’s share of an estate, and so under no circumstances may the marital deduction be reduced for any estate tax.”
While the New Jersey statute requires that total estate tax be apportioned in a manner that preserves for the benefit of decedent’s spouse, to the extent possible, the benefit of any marital deduction, the statute “does not provide absolute protection to a surviving spouse against bearing the economic burden of a tax imposed on the decedent’s estate.” “[T]o the extent that property that would otherwise have been distributed to the spouse must be used to pay the tax, it would not be covered by the marital deduction allowed by section 2056(a).” If neither the estate nor the nieces were “transferees” subject to the apportionment statute, the federal estate tax liability would be apportioned entirely to the estate.
That statute provided insufficient grounds to rule that as a matter of law any estate tax due could not affect the allowable marital deduction. The court concluded that the existing record did not allow for the court to determine the extent to which the estate tax would reduce the value of the marital share of the decedent’s estate. Tax apportioned to the fiduciary could reduce residuary distributions to the surviving spouse. If the surviving spouse pays estate tax out of assets that would otherwise have been used to pay debts or expenses, the tax would not reduce the value of the property ultimately received by the surviving spouse and would be borne by the estate’s creditors.
The court concluded this issue with the following: “[T]he ultimate incidence of that portion of tax might depend on the vagaries of the Service’s exercise of discretion in choosing among alternative sources for the tax's collection. Whoever pays that portion of the estate tax would presumably have a right to reimbursement from a fiduciary with no assets remaining under his control from which to make the required reimbursement. We need not address those potential conundrums at this juncture.”
Notably, however, the court compared the New Jersey apportionment statute to statutes and common law from other jurisdictions, and appeared to conclude that under some state laws, estate taxes owed on the gift tax component of a net gift could be apportioned to the lifetime donees.
“In a few jurisdictions in which legislators did not update their State’s apportionment statutes to reflect the 1976 changes in the Federal transfer tax regime, courts have approved apportionment of estate tax to recipients of lifetime gifts, without clear statutory mandate, apparently to remedy perceived inequities.” The court cited the cases Bunting v. Bunting, 760 A.2d 989 (Conn. App. Ct. 2000); Shepter v. Johns Hopkins Univ., 637 A.2d 1223 (Md. 1993); and In re Estate of Necaise, 915 So. 2d 449 (Miss. 2005), in each of which the court approved such apportionment. Further, the court noted that the apportionment statutes in each of those states “under statutes modeled on the 1964 Uniform Act that, if anything, provide even less textual basis for such apportionment than the New Jersey statute does.”
By contrast, the court cited two cases in which New York courts applied that State's apportionment statute more narrowly and declined to apportion estate tax to donees. See In re Metzler, 579 N.Y.S.2d 288, 290 (App. Div. 1992); In re Estate of Coven, 559 N.Y.S.2d 798 (Surr. Ct. 1990).
The New York statute provides that any estate tax “with respect to property required to be included in the gross tax estate of a decedent…shall be equitably apportioned among the persons interested in the gross tax estate,” EPTL § 2-1.8, but does not define “gross tax estate.” The court in Coven declined to apportion estate taxes to lifetime transfers because “adjusted taxable gifts are added to the tax calculation … in a separate step after the taxable estate has been determined.” However, the court in Coven had “no doubt” that “an inequity [had been] caused by the gross-up of the estate into a higher tax bracket as a result of the lifetime gifts. Estate of Coven, 559 N.Y.S.2d at 800. The court in Sommers pointed out that even though the gifts in Coven were made less than three years before the decedent’s death, “the issue of apportionment of the estate tax on any [§ 2035(b)] inclusion was not before the court.”
The court in Metzler reached the same conclusion as the court in Coven, and also noted the potential inequity: “Although it might appear that it would be more equitable to apportion the estate tax against all assets causing the tax, EPTL 2-1.9 does not authorize such apportionment.” The Metzler case went on, however, to write that the failure to apportion estate tax to the recipients of lifetime gifts may not have been inequitable because, “[i]n making the intervivos gifts to petitioner, the decedent implicitly intended that petition take those gifts free of any tax obligation.” Metzler, 579 N.Y.S. at 289. Like Coven, the Metzler case involved gifts made within three years of death, but like Coven, the Metzler case did not address the gift tax that would have been included in the gross estate under § 2035(c) even though the transferred property would not have been.
The apportionment statutes of Connecticut, Maryland, and Mississippi were modeled after the 1964 Uniform Estate Tax Apportionment Act. The Connecticut statute provides as follows:
[T]he amount of the tax [paid upon or with respect to any property required to be included in the gross estate of a decedent], except when a testator otherwise directs in his will or when, by written instrument executed inter vivos, direction is given for apportionment within the fund of taxes assessed upon the specific fund dealt with in such inter vivos instrument, shall … be equitably prorated among the persons interested in the estate to whom such property is or may be transferred or to whom any benefit accrues. C.G.S.A. § 12-401(a).
The Mississippi statute provides as follows:
The tax “shall be apportioned among all persons interested in the estate.” Miss. Code. Ann. § 27-10-7.
“Person interested in the estate” means any person including an executor, administrator, guardian, conservator or trustee, entitled to receive, or who has received, from a decedent while alive or by reason of the death of a decedent any property or interest therein included in the decedent's taxable estate. Miss. Code Ann. § 27-10-5.
If the chancery court finds that it is inequitable to apportion interest and penalties in the manner provided in this chapter because of special circumstances, it may direct apportionment thereon in the manner it finds equitable. Miss. Code Ann. § 27-10-9(2).
And the Maryland statute provides as follows:
The tax “shall be apportioned among all persons interested in the estate.” MD Code § 7-308(b)(1)
“Person interested in the estate” means any person who is entitled to receive or has received, from a decedent while alive or by reason of the death of a decedent, any property or interest in property included in the taxable estate of the decedent. MD Code § 7-308(a)(4)
If the court finds that it is inequitable to apportion interest and penalties as provided in this section because of special circumstances, the court may direct apportionment in the manner that it finds equitable. MD Code § 7-308(c)(2).
The Connecticut court in Bunting apportioned estate tax to lifetime gifts notwithstanding the following provision in the decedent’s will (which was executed after the lifetime gift): “I direct that any estate, succession, inheritance, death or transfer tax arising by reason of or in any way in connection with my death, be paid out of my estate as an expense of administration thereof, without apportionment or contribution.” The court found a latent ambiguity in the will due to the substantial lifetime gift, and wrote, “[a]lthough a gift tax return was filed, in which over two thirds of the decedent's unified estate and gift tax credit was used to avoid payment of tax on the gift at that time, testimony at trial indicated that, at the time of the gift, the decedent's attorney did not believe that the gift was taxable. Accordingly, there was no discussion concerning how taxes on the decedent's estate would be allocated in view of this rather large gift.” Bunting, 760 A.2d at 993- 94.
In the Mississippi case, Necaise, the decedent’s will provided as follows:
Each bequest under my Will, whether such bequest is specific or residual, shall be charged with the payment of its proportionate part of Mississippi and federal estate taxes payable by reason of my death including interest and penalties thereon as provided for under Mississippi Code Ann. § 27–10–1, et seq., except that in allocating the taxes among the beneficiaries, any lifetime gift made by me ... to a beneficiary, including my son RUSSELL RAYMOND NECAISE, JR., which would be an adjusted taxable gift on my estate tax return ... [,] shall be taken into account and treated as if such gift ... is a part of the bequest to such beneficiary under this Will.
Necaise, 915 So.2d at 451. Thus the decedent’s will effectively contained a direction to apportion estate taxes to lifetime gifts. However, the court in Necaise also wrote, “Clearly, Raymond meets the definition of “person interested in the estate” as provided in Miss.Code Ann. § 27–10–5(d).”
In Shepter the donee of the lifetime gift argued that the Maryland statute did not provide for apportionment of estate tax to him “because, under amendments to the IRC made by Congress after Maryland adopted the Uniform Act, the transfer to him is not treated as part of the ‘taxable estate’ … but it is reported on the return as an ‘adjusted taxable gift’.” The Maryland court responded:
Following [the 1976] change in the IRC, the National Conference of Commissioners on Uniform State Laws saw no need to amend the Uniform Act to address the change, and the General Assembly has not done so. Nevertheless, apportionments continue to be made of the total estate tax imposed by IRC § 2001. This practical contemporaneous construction, that has existed for seventeen years, reflects that … the tax imposed by IRC § 2001 … [is] computed by including values reported on the return as “adjusted taxable gifts” per IRC § 2001(b)(1)(B).”
The Shepter case involved a gift made within three years of death, so again, although the transferred property would not have been included in the decedent’s taxable estate, the gift tax on that gift would have been son included under § 2035(b).
After the Shepter decision, the Maryland legislature adopted a law that repealed and reenacted without amendment Md. Code Ann., Tax–Gen. secs. 7–308(a)(1) and (4), the purpose of which was “confirming that apportionment of a decedent's federal and Maryland taxes is not to be made to interests not included in the decedent's taxable estate for federal estate purposes notwithstanding a certain case holding; confirming that an apportionment of a decedent's federal or Maryland estate taxes may not be made to gifts not included in the decedent's federal taxable estate…” 1995 Md. Laws 3218, 3219.
That Maryland law, while not amending the statutory provisions at all, also provided that the references in the statute to “taxable estate,” “interest,” and “interests” “do not include any interest of the decedent that is not included in the value of the decedent's taxable estate determined under §§ 2001(b)(1)(A) and 2051 of the Internal Revenue Code of 1986, and specifically do not include any adjusted taxable gifts of the decedent as defined in § 2001(b) of the Internal Revenue Code, notwithstanding any holding or dictum to the contrary in Shepter v. Johns Hopkins University, 334 Md. 82, 637 A.2d, 1223 (1994).” The law also provided that “apportionment of a decedent's federal estate tax may not be made … to any adjusted taxable gift of the decedent, as defined in § 2001(b) of the Internal Revenue Code.”
Implications for Net Gifts
The Uniform Estate Tax Apportionment Act had not been amended after the 1976 change to the federal estate tax law until 2003. The 2003 Uniform Act defines “Apportionable estate as “the value of the gross estate as finally determined for purposes of the estate to be apportioned reduced by … any amount added to the decedent’s gross estate because of a gift tax on transfers made before death.”
The New York courts in Coven and Metzler addressed cases involving gifts made within three years of death. While both courts declined to apportion estate taxes to the lifetime gifts, neither court addressed the inclusion in the gross estate of gift tax paid under § 2035(b).
The Connecticut and Mississippi cases, Bunting and Necaise, respectively, interpreted statutes in a way that resulted in apportionment of estate taxes to donees of lifetime gifts. The Connecticut apportionment statute applies to property “included in the gross estate,” and the Mississippi statute applies to property “included in the taxable estate.” Neither case involved a gift made within three years of death. But, if the courts were willing to apply this language to adjusted taxable gifts (which are not included in the gross estate or taxable estate), why would they not apply the statutes to gift taxes on gifts made within three years of death, which are included in the gross estate and the taxable estate?
The Shepter case in Maryland did involve a gift made within three years of death, but section 2035 was not even mentioned in the opinion. Even after the action of the Maryland legislature, a Maryland court may treat gift tax included in the federal taxable estate differently than adjusted taxable gifts themselves, which are not included in the federal taxable estate. The Maryland law passed in 1995 referred to “items not included in the value of the decedent's taxable estate determined under §§ 2001(b)(1)(A) and 2051” and specifically referred to “adjusted taxable gifts.” Gift taxes included under § 2035(b) are included in the federal taxable estate are not “adjusted taxable gifts,” and are included in the taxable estate determined under § 2001(b)(1)(A).
Further, both the Maryland and Mississippi statutes directly provide that the court may deviate from the statutory apportionment scheme if it “finds that it is inequitable to apportion interest and penalties as provided,” in which case it may “direct apportionment in the manner that it finds equitable.” The Connecticut statute provides that estate taxes shall be “equitably prorated.” The New Jersey statute contains no such provision!
The 2003 Uniform Act omits any reference to a courts power to “remedy perceived inequities” by deviating from the statutory scheme. Under the 2003 Uniform Act, the only circumstance under which the recipient of a lifetime gift could be required to pay estate tax is when any estate tax due “cannot be collected from [a] person” from whom it is due, and only then after all other assets in the “apportionable estate have been exhausted.” However, many state apportionment statutes, including the five described above, have not been amended since the 2003 Uniform Act. Some states (like my home state of Illinois) do not even have estate tax apportionment statutes.
A glaring solution to this should be to provide for the apportionment of estate taxes in express terms in the estate planning documents, but see the provision in the decedent’s will in Bunting, which the court held was subject to a latent ambiguity.
Portions of materials from the 2015 RPTE Spring Symposia presentation on the Steinberg case and net net gifts (by this author and Tiffany Carmona) are appended to this outline. If estate tax resulting from the inclusion under § 2035(b) of gift tax paid on a gift made within three years of death is apportioned to the donee of the gift, is the gift then a net net gift even without an express agreement to that effect? Should the value of the gift be reduced by the estate tax liability placed on the donee of the gift (and an amended Form 709 filed)? And by that point, the fact of death within three years of the gift is known, so does that change the actuarial computation of the net net gift amount? In states where the statute has been held to apportion estate taxes to lifetime gifts, can the donor treat that burden of estate tax on the donee as consideration that reduces the value of the gift? One concern raised regarding net net gifts was the possibility that the assumption by the donee of the § 2035(b) estate tax liability would, itself, be considered a separate assets includible in the gross estate. Would that apply if the donor and donee “acknowledge” that any estate taxes incurred due to § 2035(b) inclusion will be apportioned to the donee under state law? Finally, would the net net gift be a better result if all assets remaining in the gross estate would otherwise qualify for a marital deduction?
CCA 201745012 (Nov. 9, 2017)
Purchase of GRAT remainder by grantor is held not to be for adequate consideration for either gift tax or estate tax purposes.
On Date 1, Donor formed Trust 1, an irrevocable discretionary trust for the benefit of Donor’s first spouse and issue. Trust 1 terminates on the later of the death of Donor or his first spouse, at which time the principal and any accumulated income are distributed outright to Donor’s issue per stirpes. Donor’s first spouse predeceased him; Donor then married Spouse.
On Date 2, Donor formed Trust 2, an irrevocable trust – a GRAT – for the benefit of Donor and his issue. Under the terms of Trust 2, an annuity is payable to Donor for the term of the trust, and the remainder is payable under the terms of Trust 1.
On Date 3, Donor formed Trust 3, a GRAT for the benefit of Donor and his issue. Under the terms of Trust 3, an annuity is payable to Donor for the term of the trust, and the remainder is payable under the terms of Trust 1.
On Date 4, a date before the expiration of the annuity terms of Trusts 2 and 3, Donor bought the remainder interests in Trusts 2 and 3 from the trustees of Trust
1. Donor paid the purchase price with two unsecured promissory notes. Donor died the following day (before the annuity terms of Trusts 2 and 3 expired).
Donor’s executor filed a gift tax return and reported the purchases of the remainder interests as non-gift transfers, asserting that Donor received adequate and full consideration in money or money’s worth in the form of the remainder interests in Trusts 2 and 3. Spouse elected to split gifts with Donor.
Donor’s executor filed an estate tax return, and included the corpus of Trusts 2 and 3 in the gross estate. Donor’s executor deducted the value of the outstanding promissory notes payable to the trustees of Trust 1 as claims against the estate.
The IRS analyzed two issues: whether adequate consideration was provided by Donor for the GRAT remainder interests, and whether the notes were properly deductible on the estate tax return (also an “adequate consideration” issue, but under § 2053(c)(1)(A)).
Adequate Consideration. The Chief Counsel’s Office relied on Commissioner v. Wemyss, 324 U.S. 303 (1945) and Merrill v. Fahs, 324 U.S. 308 (1945), in which the Supreme Court held that “adequate and full consideration in money or money’s worth” has a different meaning for contracts law purposes then it does for gift tax purposes. The gift tax law requires consideration that is reducible to a money value and thereby replenishes the recipient’s estate for the value of the property for which it was transferred. The right to decide how property shall be disposed of may have value for contract law purposes, but it does not replenish the transferor’s estate and thus does not constitute adequate and full consideration for gift tax purposes.
Here, Donor’s liability on the promissory notes depleted his taxable estate. However, the Chief Counsel’s Office wrote, “in the context of a deathbed purchase of a remainder interest in transferred property in which a donor has retained a § 2036 ‘string,’ the receipt of the remainder does not increase the value of the donor’s taxable estate, because the value of the entire property, including that of the remainder, will be includible in the donor’s gross estate pursuant to § 2036(a)(1).” Thus, the Donor’s receipt of the remainder interests cannot constitute adequate and full consideration in money or money’s worth for gift tax purposes.
Deductibility of the Notes. Section 2053(c)(1)(A) provides, in part, that the deduction allowed in the case of claims against the estate, unpaid mortgages, or any indebtedness shall, when founded on a promise or agreement, be limited to the extent that they were contracted bona fide and for an adequate and full consideration in money or money’s worth. Treas. Reg. § 20.2053- 1(b)(2)(i) provides, in part, that amounts allowed as deductions under § 2053 must be expenses and claims that are bona fide in nature. No deduction is permissible to the extent it is founded on a transfer that is essentially donative in character (a mere cloak for a gift or bequest). Treas. Reg. § 20.2053- 4(d)(5) provides in part, that the deduction for a claim founded upon a promise or agreement is limited to the extent that the promise or agreement was bona fide and in exchange for adequate and full consideration in money or money’s worth; that is, the promise or agreement must have been bargained for at arm’s length and the price must have been an adequate and full equivalent reducible to a money value. In Merrill v. Fahs, the Supreme Court held that adequate and full consideration should be deemed to have the same meaning in both the estate tax and the gift tax. 324 U.S. at 313 (1945).
The Chief Counsel’s Office concluded that the notes were not deductible as a claim against Donor’s estate: “[w]here the purchase of the remainder occurs on the donor’s deathbed while he is holding a § 2036 ‘string’ to the transferred property, the remainder does not increase the value of the donor’s taxable estate … because the entire value of the transferred property, including that of the remainder, will be includible in the donor’s gross estate pursuant to § 2036(a)(1).” For that reason, the Donor’s deathbed receipt of the remainder interests cannot constitute adequate and full consideration within the meaning of § 2053(c)(1)(A). The CCA concluded that the “promissory notes are a mere cloak for a gift,” citing Treas. Reg. § 20.2053-1(b)(2)(i).
Note that the Chief Counsel’s Office made reference several times to the “donor’s deathbed.” Would the result be any different if the Donor survived several years but nevertheless died before the end of the GRAT term? It seems the same analysis, in which the Donor’s estate was not diminished by the purchase of the remainder interest, would apply.
PLRs 201730012, 201730017, and 201730018 (July 28, 2017)
No charitable deduction is allowed upon conversion of a nongrantor trust- CLAT to a grantor trust-CLAT.
In these PLRs, grantor had created CLATs that were nongrantor trusts. As such, the trust was previously allowed charitable deductions under § 642(c)(1) for amounts of gross income included in the annuity amounts each year. The trustee sought to amend the trust agreements pursuant to state law to permit the “substitutor” to have the power, exercisable at any time in a nonfiduciary capacity, without the approval or consent of any person in a fiduciary capacity, to acquire or reacquire trust principal by substituting other property of an equivalent value, determined as of the date of substitution.
In each PLR, the grantor requested three rulings: (1) the conversion of the CLAT from a nongrantor trust to a grantor trust (assuming the substitutor is found to hold the substitution power in a nonfiduciary capacity) is not a taxable transfer of property held by the trust to the grantor as settlor for income tax purposes; (2) the conversion of the CLAT from a nongrantor trust to a grantor trust is not an act of self-dealing that would result in a tax under § 4941; and (3) the conversion of the CLAT from a nongrantor trust to a grantor trust would result in an income tax charitable deduction for the grantor in the year of conversion under § 170.
While granting favorable rulings on the first two requests, the IRS did not allow the grantor to take a charitable deduction in the year of conversion. Rev. Proc. 2007-45 provides that a donor to a grantor CLAT may claim a federal income tax charitable deduction under § 170(a) in the year that assets are irrevocably transferred to the trust. Because the conversion of the CLAT from a nongrantor trust to a grantor trust was not a transfer of property, the grantor is not able to take an income tax charitable deduction under § 170(a).