Estate of Moore: Tax Court Finds Estate Tax Traps in ‘Deathbed’ Plan

Tax Court Finds Estate Tax Inclusion Under § 2036 in “Deathbed” Estate Plan

by Benjamin A. Cohen-Kurzrock
Tax court gavel and scale

Tax court gavel and scale

On April 7, Tax Court Judge Mark V. Holmes issued a memorandum opinion that applied section 2036 to a decedent’s transfer of valuable assets to a closely held entity as part of an estate plan that was developed and implemented shortly before the decedent’s death. Holmes took this opportunity to explain further the mechanics of the consideration offset under section 2043 for cases involving a decedent’s transfer of assets to a closely held entity that are subject to section 2036.  In doing so, the Tax Court added to its existing case law in this arena, with its most recent previous decision being Estate of Powell v. Commissioner.

Holmes also addressed other, interesting issues that occur when practitioners help clients develop their estate plan.  These issues include:

  • the deductibility under section 2055 of assets that ultimately pass to a charity based on the finally determined tax treatment of related transfers;
  • the deductibility under section 2053 of reasonable attorney fees for estate administration; and
  • the existence of bona fide debt (as opposed to a gift or a disguised distribution).

Factual Findings of the Tax Court

Howard Moore (the decedent) was a land leveler in Arizona.  Through hard work, he established Moore Farms, a large and desirable agribusiness.  In late 2004, Moore began negotiating the sale of Moore Farms to Mellon Farms, a neighboring family-operated farm.  Around this time, Moore’s health failed, resulting in his hospitalization in December 2004 for congestive heart failure and related illnesses.  On December 15, 2004, Moore was discharged to hospice after his doctors described his condition as “critical” and estimated his life expectancy at six months.

As the hospital discharged him, Moore started to work on his estate plan (hospice records showed that this work was Moore’s principal focus) with the help of an experienced estate planning attorney who he previously consulted for basic planning documents.  To that end, on December 20, 2004, Moore established a foundation, five trusts, and a family limited partnership.  Those entities are described in the table.

Howard V. Moore Foundation

The foundation was a charitable entity that made contributions to the Community Foundation of Southern Arizona, a section 501(c)(3) entity that, in turn, provided monetary support to several charities based on decisions that the Community Foundation made together with the foundation.

The Howard V. Moore Living Trust

The living trust was a revocable trust held for Moore’s benefit during his lifetime to which he transferred all his real and intangible personal property, including Moore Farms.  After Moore’s death, the trust’s residue passed to the CLAT and the children’s trusts.

The Howard V. Moore Charitable Lead Annuity Trust

The CLAT was an irrevocable trust that made annuity payments to the foundation using assets contributed to it by the living trust according to a formula gift.

The Howard V. Moore Children’s Trusts

The children’s trusts were four separate irrevocable trusts held for the benefit of Moore’s children that the living trust funded with assets remaining after the formula gift to the CLAT.

The Howard V. Family Management Trust

The management rust was an irrevocable trust benefiting Moore during his lifetime, after which any remaining assets passed to his children via the living trust.  The purpose of the management trust was to hold a 1 percent general partnership interest in the Moore FLP.

The Howard V. Irrevocable Trust No. 1

The irrevocable trust was an irrevocable needs trust benefiting Moore’s children during his lifetime, after which the trustee was instructed to distribute to the living trust “the value of any asset of this trust which is included in [Moore’s] gross estate.”a

The Howard V. Moore Family Limited Partnership

The Moore FLP was a partnership formed among the management trust (1 percent general partner), the living trust (95 percent limited partner), and Howard’s children (each a 1 percent limited partner) and funded with cash and Moore Farms (which was sold shortly after formation).

aId. at *56.

On February 4, 2005, Mellon Farms purchased Moore Farms for $16.5 million.  The proceeds were split between the living trust and the Moore FLP based on their respective 20 percent and 80 percent interests in Moore Farms.  Proceeds from this sale were used for Moore’s benefit, including by:

  • the living trust and Moore FLP paying $200,000 that Moore owed to his estate planning attorney; and
  • the Moore FLP making:
    • $500,000 “advances” to each of Moore’s four children;
    • a $500,000 gift to Moore’s grandson; and
    • a $2 million non-pro rata distribution to the living trust.

Around this time, the Moore FLP also opened an investment account that it funded using living trust assets.

On March 7, 2005, the living trust sold its 95 percent Moore FLP limited partnership interest to the irrevocable trust for $5.3 million based on the partnership’s net asset value, less a 53 percent discount.  The irrevocable trust paid the purchase price using cash of $500,000 and promissory notes.

In late March 2005, Moore died.  The estate reported his 2005 gift to the irrevocable trust on a gift tax return for that year.  Moore’s estate tax return reported as assets only his beneficial interest in the management trust (valued at $540,000) and notes receivable from the irrevocable trust (valued at $4.8 million).  Moore’s estate also claimed as deductions:

  • a debt owed by the living trust to the Moore FLP of $2 million (related to the non-pro rata distribution);
  • a charitable deduction of $4.8 million; and
  • estate administration expenses of $475,000 for attorney fees paid to Moore’s estate planning attorney.

The IRS assessed gift and estate tax deficiencies after the examination, having determined that Moore’s estate plan invoked section 2036.  The IRS also challenged each deduction claimed by Moore’s estate.

Moore’s Transfer of Moore Farms to Moore FLP Invoked Section 2036(a)(1) Only; Section 2036(a)(2) Not Addressed

The IRS claimed that section 2036 applied to the contribution of Moore Farms to Moore FLP and, in the alternative, to the living trust’s March 7 sale to the irrevocable trust.  The Tax Court described section 2036 as creating “a general rule that brings back all property that a decedent transfers before he dies, subject to two exceptions.” The first exception applies to bona fide sales for full and adequate consideration.  The second exception applies to “any property that Howard transferred in which he did not keep a right to possession, enjoyment, or rights to the issue of the transferred property.

As to the first exception, the Tax Court emphasized that the inquiry into whether a transfer is bona fide focuses on motives.  When looking at motives, the Tax Court acknowledged that it does not apply a uniform test. Rather, it analyzes some combination of the transfer’s significant and legitimate nontax purpose and genuine arm’s-length nature.

Moore’s family claimed that the Moore FLP’s purposes were twofold: (1) to bring together dysfunctional family members to help manage his business, and (2) to protect against liabilities, creditors, and bad marriages.  The Tax Court rejected these claims.

As to the first purpose, the Tax Court explained that “there was no business to run” because Moore (alone) sold Moore Farms within days of the formation and funding of the Moore FLP. Further, an investment adviser managed the liquid assets that remained in the Moore FLP after the sale, with there being no evidence that the family took any interest in their management.  The Tax Court was equally skeptical of the desire for creditor protection because (a) Moore’s children were “unable to name any possible creditors and were unaware of any threats of possible litigation” and (b) the Moore FLP “held a significant amount of capital for any creditor to pull from.” Instead, the Tax Court identified Moore’s poor health, statements, and unilateral actions, coupled with the overall testamentary nature of the estate plan, as factors showing the absence of a bona fide sale.

The Tax Court also held that an implied agreement existed under which Moore retained possession or enjoyment over Moore Farms.  Evidence of this agreement included Moore’s:

  • continuing to live on and operate the farm after its contribution to and sale by the Moore FLP;
  • using non-pro rata distributions from the Moore FLP to pay personal expenses and make gifts to his children and grandchildren;
  • making all decisions related to Moore FLP assets; and
  • making statements that his goal was to minimize taxes and retain control over his property.

Consequently, the Tax Court found that section 2036(a)(1) applied to Moore’s transfer of Moore Farms, and as a result, the Tax Court did not evaluate the IRS’s other theories for invoking section 2036.

The Tax Court Revisits the Consideration Offset Under Section 2043

Section 2043 establishes a consideration offset for some lifetime transfers by a decedent that sections 2035 through 2038 include in the gross estate, resulting in a net inclusion amount.  In Estate of Powell, the most recent Tax Court decision addressing the interplay between sections 2036 and 2043, the Tax Court described this net inclusion amount as “equal[ing] any discount applied in valuing the partnership interest the decedent received plus any appreciation (or less any depreciation) in the value of the transferred assets between the date of the transfer and the date of death.” This method for determining the net inclusion amount could result in the duplicative addition to or reduction from transfer taxes, depending on whether posttransfer valuation increases or declines in the value of the transferred assets are reflected in the value of the closely held interest owned by the decedent.

The Tax Court discussion of section 2043 appears to be dicta in this case.  Building on Estate of Powell, the Tax Court designed a formula for determining the appropriate inclusion amount and provided four hypothetical demonstrative examples of its application:

Remaining ConsiderationDODb

plus sections 2035-38 PropertyDOD

less Consideration ReceivedTD

Net Inclusion Amount

DOD = Date of Death

TD = Transfer Date

b Because this variable is “not limited by tracing rules,” whatever is left of the original consideration is included, as are any proceeds from subsequent transfers that are included in the gross estate under section 2033; but, property that leaves the estate between (i) the transfer that is subject to sections 2036 through 2038 and (ii) the decedent’s death is not generally included in the gross estate. Estate of Moore at *45-46.

Example 1 (Constant Value).  A decedent contributes land valued at $1,000 to a partnership in exchange for interests worth $500.  The transfer is subject to sections 2035-2038.  There were no changes in value between the contribution date and the date of death.  As a result, the inclusion amount equals $1,000 ($500 + $1,000 - $500).

Example 2 (Inflating Value).  Same facts as Example 1, except that the date-of-death values of the land and partnership interests have doubled between the contribution date and the date of death.  As a result, the inclusion amount equals $2,500 ($1,000 + $2,000 - $500).

Example 3 (Declining Value).  Same facts as Example 1, except that the date of death values of the land and partnership interests have halved between the contribution date and the date of death.  As a result, the inclusion amount equals $250 ($250 + $500 - $500).

Example 3 (Discounting; Simple)Similar facts as Example 1, except that the decedent receives limited partnership interests subject to a 25 percent discount in exchange for the contribution of land with a value of $1,000.  Post-discount, the limited partnership interests received by the decedent have a value of $750 on the contribution date.  There was no change in the value between the contribution date and the date of death.  As a result, the inclusion amount equals $1,000 ($750 + $1,000 - $750).

Example 4 (Discounting; Complex).  Same facts as Example 3, except that the partnership sells the land for $1,000 and distributes $450 to the decedent.  There are no other changes to the value of the partnership between the contribution date and the date of death.  As a result, the inclusion amount equals $700 ($450 + $1,000 - $750), plus the $450 distribution under section 2033.

Applying the above principles, the Tax Court truncated the net inclusion amount formula to the date of death value of Moore Farms minus the assets transferred out of Moore’s estate between the farm’s sale and his death.  The Tax Court left the parties to handle the “difficult” computation of this net inclusion amount.

Additional Deductions for Contingent Charitable Transfers Were Disallowed Under Section 2055

Based on the IRS’s position that section 2036(a) applied to either (i) Moore’s transfer of Moore Farms or (ii) the living trust’s sale of limited partnership interests to the irrevocable trust, his estate sought an additional charitable deduction under section 2055 for amounts that would pass to the CLAT by operation of the irrevocable trust’s formula clause, which would cause an increase to the living trust’s formula charitable gift.  The IRS opposed this additional deduction, claiming that it was “contingent on the IRS’s examination of the estate’s return.” The Tax Court sided with the IRS.

The Tax Court identified two problems with the position taken by Moore’s estate.  First, its holding that section 2036 applied to his transfer of Moore Farms never triggered the operative language of irrevocable trust’s formula clause because the clause applied only to “any asset of this trust” (Moore Farms was not a trust asset at death because of the sale to Mellon Farms). Second, and more generally, this deemed transfer from the irrevocable trust to the living trust to the CLAT was too contingent to permit a charitable deduction under section 2055.

On the latter point, the Tax Court reasoned as follows:
Whether the [living trust] would get additional funds from the [irrevocable trust] to transfer to the [CLAT] was not ascertainable at [Moore’s] death but only after an audit by the Commissioner, followed by a determination that additional property should be included in [Moore’s] estate by either the successful defense of that position or the estate’s acquiescence to his determination.  For the exception to apply, it would have to have been almost certain that the Commissioner would not only challenge, but also successfully challenge[,] the value of the estate.  We do not think that’s a reasonable conclusion.

The Tax Court’s focus on whether a transfer from the irrevocable trust would ever occur distinguished the case before it from Estate of Christiansen v. Commissioner, and Estate of Petter v. Commissioner, each of which respected a formula clause that relied on values as finally determined for federal gift and estate tax purposes when determining a charitable deduction.  The Tax Court emphasized that — unlike the situations in Estate of Christiansen and Estate of Petter where it was known that the charity would get a transfer of assets or value — the irrevocable trust’s formula clause “does not say that the Living Trust will receive a transfer of assets of unknown value.” Rather: “it says that whether the Living Trust will even receive a transfer of assets is unknown — contingent on an examination by the Commissioner. . . . Here, we don’t know if the charity will get any additional assets at all.”

Thus, an additional charitable deduction was impermissible under section 2055.

Attorney Fees of $475,000 for a Simple Estate Were Excessive

Moore’s estate planning attorney was paid $475,000 for administering his estate.  The estate tax return claimed a deduction for these fees under section 2053.  The IRS challenged this deduction, arguing that those fees were unreasonably high and not actually and necessarily incurred in the administration of Moore’s estate.

Section 2053 permits deductions for attorney fees if they are actually and necessarily incurred in an estate’s administration, which a decedent’s estate demonstrates by showing that (1) the fees are allowable under local law and (2) the expenses meet specific regulatory conditions.  After considering Arizona law, the Tax Court determined that the $475,000 charged by Moore’s estate planning attorney for administering his estate was unreasonable.  There was no evidence showing the amount or nature of the work the attorney performed, plus Moore’s estate was straightforward.  The Tax Court rejected the argument that its precedent in Estate of Baird v. Commissioner allowed for deductions of attorney fees that are less than 4 percent of the total estate’s value.

As a result, the estate lost on all disputed issues.

Reprinted from Tax Notes Federal, May 25, 2020, p. 1359

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Benjamin A. Cohen-Kurzrock

Associate at Baker Botts LLP

Benjamin A. Cohen-Kurzrock