KEY CASES, RULINGS,
LEGISLATION
2002-2003
Stephan R. Leimberg
Portions Courtesy LISI (http://www.leimbergservices.com)
Portions Courtesy Tax Planning With Life Insurance (800 950 1216)
PART I –
ESTATE TAX ISSUES
ESTATE TAX REPEAL BILL: H.R. 8.
RESULT: HOUSE VOTES TO SUNSET ESTATE TAX! 264 to 163, the House
of Representatives voted to sunset the federal estate tax permanently.
FACTS: The bill, introduced by Republican Congresswoman Jennifer Dunn of
Washington state, would eliminate the scheduled 2011 sun setting of the estate tax repeal
enacted in 2001's tax legislation. The House rejected at the same time a proposal offered
by North Dakota Congressman Pomeroy, 239 to 188, that would have increased the
exemption significantly.
The issue now will be addressed by Senate leaders facing massive budgetary
considerations.
PLANNING:
● Don’t panic and don’t plan for no tax. Many a slip twixt spoon and lip. And
many a Congress with many a deficit problem and/or political ax to grind.
● Beware of apathy and under-liquidity!
VALUATION CASES AND RULINGS
DEPUTY: Deputy Estate v. Commissioner, T.C. Memo 2003-176 (June 13, 2003).
RESULT: The Tax Court considered the components of discounts for lack of
control and lack of marketability in a matrix offered by the estate appraiser.
FACTS: The Tax Court determined, for estate tax purposes, the value of a 19.99%
stock holding in an almost 100 year old corporation engaged in the manufacturing of
aluminum pontoon and fishing boats.
The decedent had transferred the stock holding to a family limited partnership, Deputy,
less than two months prior to death. The stock constituted approximately 90% of the
assets in the FLP, which itself had been formed within a year of the decedent’s death.
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The estate took a 44% combined discount for lack of marketability and control-Estate:
44%. The IRS knocked that down to 25% and the Tax Court brought it up to 30%.
The Tax Court selected 10% as a proper capitalization rate and weighted Godfrey income
in the year of death the highest, but also factored in the three preceding years, in
sequentially decreasing weights.
The Tax Court noted that “an asset value approach is inappropriate in valuing a long-
established, financially successful operating company.”
The Tax Court didn’t buy the IRS appraiser’s position that no discount for lack of control
was appropriate when utilizing the income approach.
Company Specific Matrix:
● Financial Information
● Investment Size
● Company Outlook
● Ability to Control
● Restrictions on Transferability
● Dividend Payout and History
PLANNING:
● Consider the matrix approach as used here.
● Exert more influence on valuation process.
● Be reasonable but not overly conservative
McCORD: McCord v. Commissioner, 120 T.C. No. 13 (May 14, 2003); Hamm v.
Commissioner, T.C. Memo 1961-347, aff’d, 325 F.2d 934 (8th Cir. 1963); Commissioner
v. Procter, 142 F.2d 824 (4th Cir. 1944).
RESULT: The taxpayers argued that, by a defined value formula clause, any
value in excess of the described amount in a defined value clause would qualify for a
gift tax charitable deduction. But the Court refused to allow taxpayers to use that
formula clause to cap potential gift tax liability,
FACTS: An FLP was formed between 4 sons (general partners), H&W (limited
partners), and H, W, and FLP (children). (Marketable securities 65%, Real estate
partnerships 30%, Real estate, oil and gas partnerships, oil and gas interests 5%).
A formula clause provided that children and the trusts were to receive portions of the gifted
interest having an aggregate fair market value of $6,910,933.
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If the fair market value of the gifted interest exceeded $6,910,933, then the city’s
symphony orchestra was to receive a portion of the gifted interest having a fair market
value equal to such excess, up to $134,000.
If any portion of the gifted interest remained after the allocations to the children, trusts, and
symphony, then CFT [Communities Foundation of Texas] was to receive that portion (i.e.,
the portion representing any residual value in excess of $7,044,933).
The assignment agreement leaves to the assignees the task of allocating the gifted interest
among themselves.
The charities (and their outside counsel) reviewed an appraisal report that was the basis of
the allocation, and determined that it was not necessary for them to obtain their own
appraisals.
The court allowed an overall discount of 32%, after applying a 15% minority discount, and
a 20% discount on the remaining value.
Court held that specific clause was not "self-effectuating" because it was based on the
FMV of transferred interest, rather than on "fair market value as finally determined for
Federal gift tax purposes."
PLANNING:
● Don’t count on defined value clause to minimize transfer tax
● Don’t count on de minimus charitable interest to save the day
STRANGI: Strangi v. Commissioner T.C. Memo 2003-145 (May 20, 2003); E.g. Estate
of Reichardt v. Commissioner, 114 T.C. 144 (2000); Estate of Schauerhamer v.
Commissioner, T.C. Memo. 1997-242.)
RESULT: Section 2036(a)(1) applies to require inclusion of the corporation and
turnkey FLP created by Strangi. Existence of FLP and corporation ignored for
estate tax purposes.
FACTS: Strangi contributed 98% of wealth was to partnership and retained 99%
limited partnership interest. 1% general partner was new corporation owned 47% by
Strangi, 53% by his children. (Children later gave 1% to a Foundation.)
Management agreement with Strangi’s son-in-law who held Strangi’s power of attorney
enabled him to manage day-to-day business of corporation and partnership.
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Partnership agreement: “Income, after deducting certain listed expenses “shall be
distributed at such times and in such amounts as the Managing General Partner, in its sole
discretion, shall determine, taking into account the reasonable business needs of the
Partnership (including plan for expansion of the Partnership’s business).”
Various distributions were made to or for decedent or decedent’s estate (including home
health care, medical expenses of health care provider, funeral expenses, estate
administration expenses, debts of decedent, specific bequest, and estate and inheritance
taxes).
Once again, the court pointed out that where a decedent has retained legally enforceable
rights to designate who can enjoy property and income from an entity; it is immaterial
whether the documents and relationships create rights exercisable by decedent alone or in
conjunction with other corporate shareholders and the corporation’s president. Strangi
“held the right, in conjunction with one or more other Stranco directors, to declare
dividends.” Strangi was the largest shareholder and all decisions were ultimately made by
his son-in-law who held his attorney-in-fact as the manager of the corporation and
partnership.
Note that this court interpreted the “in connection with” language in the statute and
regulations very broadly. Does it imply that any family entity could be ignored under
Code Section 2036(a)(2) because the decedent—regardless how small of an interest
retained held - would hold the power, “in connection with others” to vote its interest as a
member of the entity (i) to affect indirectly when income distributions would be made, and
(ii) to liquidate the entity and distribute its assets? I think this is beyond where the courts
are going – but not far beyond where the IRS would like to go.
Unlike a real business where the flow of funds depends on economic and business realities,
here, the FLP and corporation held only monetary or investment assets.”
Here, there were no unrelated minority shareholders who could enforce duties by suit.
Most of the duties, if any, were owed to Strangi himself. According to the court,
“Intrafamily fiduciary duties within an investment vehicle simply are not equivalent in
nature to the obligations created by the United States v. Byrum, supra, scenario.” The fact
that there was a 1% shareholder of the corporation was “no more than window dressing.”
“A charity given a gratuitous 1-percent interest would not realistically exercise any
meaningful oversight.”
There was no bona fide arm’s length transaction since all documents were prepared by
Strangi’s son in law and there was no meaningful negotiation or bargaining with other
interest-holders.
Nor was there adequate and full consideration to take the transaction out of Code Section
2036’s reach. The court held that “Full and adequate consideration does not exist where
there is a mere “recycling” of value through partnership or corporate solution. Without any
change whatsoever in the underlying pool of assets or prospect for profit, as, for example,
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where others make contributions of property or services in the interest of true joint
ownership or enterprise, there exists nothing but a circuitous ‘recycling’ of value.”
Decedent contributed more than 99% of the total property and received back an interest
“the value of which derived almost exclusively from the assets he had just assigned.” He
retained up until death “in connection with” the other owners power to liquidate and
distribute the entire assets of the entity.
Planning:
● One or more parties other than the decedent should contribute substantial
assets to the partnership.
● Don’t just call yourself a duck. Walk the walk and talk the talk. Observe
corporate and partnership formalities.
● Retain sufficient liquid (not just “liquefiable”) assets outside the partnership
to provide realistically for anticipated living expenses.
● Don’t transfer main residence (or other “personal assets) to partnership or
LLC.
● If your client must use partnership assets, insist on arms’ length negotiating
and that the payment actually made – now!
● Be sure distributions from entity are based on business rather than personal
reasons and are made proportionate to ownership.
● Don’t directly or indirectly retain sole discretion over cash distributions.
Here, partnership agreement gave the managing partner “sole discretion”
over distributing income in excess of business needs.
Note: Strangi has not been reviewed by full Tax Court and will almost certainly be
appealed to 5th Circuit (which previously rejected a section 2036(a)(1) and 2036(a)(2)
claim by the IRS in Church v. U.S., 268 F.3d 1063 (5th Cir. 2001)(unpublished opinion)).
HARPER: Morton B. Harper, T.C. Memo 2002-121,
http://www.ustaxcourt.gov/InOpHistoric/Harper5.TCM.WPD.pdf (May 15, 2002);
Christine M. Hackl v. Commissioner, 118 T.C. No. 14 (March 27, 2002); Church v. United
States, 2000-1 USTC 60,369 (W.D. Tex. 2000), aff’d. without published opinion, 268 F.3d
1063 (5th Cir. 2001).
RESULT: In Harper, the Tax Court held that the assets of a family partnership
were included in the decedent’s estate under Section 2036(a). The commingling of the
decedent’s assets with partnership assets and the pattern of partnership distributions
to the decedent both allowed the court to conclude that there was an implied
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agreement that the decedent would retain the possession or enjoyment of the assets
within the meaning of section 2036.
FACTS: In 1994, Mr. Harper, an 85-year-old lawyer suffering from cancer, created a
family partnership called Harper Financial Company, L.P. He put virtually all of his assets
into HFLP, except for his personal effects, a checking account, a car, and his condo.
Harper’s children, Michael and Lynn, were the general partners. Michael had an 0.6%
interest, and Lynn had an 0.4% interest. Harper’s revocable trust was the limited partner,
with a 99% interest. Mr. Harper and his children were the trustees, although only Harper
performed any meaningful functions as trustee.
The partnership agreement was effective as of January 1, 1994. But it was not signed until
May or June 1994. The partnership certificate was not filed until June 1994.
On July 1, 1994, Mr. Harper gave a 36% limited partnership interest to Lynn and a 24%
limited partnership interest to Michael, reserving a 4.25% guaranteed payment.
● Harper didn’t begin transferring his assets to HFLP until July 26, 1994. It
took four months until all of the transfers were completed.
● The other partners didn’t contribute any assets to HFLP.
● Michael didn’t open a bank account for the partnership until September 23,
1994.
● Michael didn’t deposit any partnership income into the account until
October 13, 1994.
● In the interim, the partnership’s assets were commingled with Mr. Harper’s
assets.
● HFLP made disproportionate distributions.
● HFLP didn’t pay the guaranteed payments.
● Distributions were linked to contemporaneous expenses of Mr. Harper or
his estate.
● After Harper’s death, his children hired an accountant to create books and
records for the partnership.
The IRS argued that the partnership should be disregarded because it lacked economic
substance and that the partnership assets should be included in Harper’s estate under
Section 2036(a). Finally, the IRS argued that the discounts claimed were excessive.
Under Section 2036(a), if a taxpayer transfers property (except in the case of a bona fide
sale for full consideration in money or money’s worth), but retains possession or
enjoyment of the property, or the income from the property, until death, the property will
still be included in the taxpayer’s estate. NOTE: Treas. Reg. § 20.2036-1(a) makes it clear
that the retained possession or enjoyment need not be formal; it is sufficient for inclusion
that there is an implied understanding between the parties.
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The Tax Court found that there was simply a recycling of value, noting that the other
partners didn’t put in any property or services. The Tax Court said that such instances of
pure recycling do not rise to the level of a payment of consideration for purposes of
Section 2036. The court then held that where a transaction involves only the genre of
value recycling, and does not appear to be motivated primarily by legitimate business
concerns, no transfer for consideration within the meaning of Section 2036(a) has taken
place. The court thus did not have to reach the IRS argument that the partnership should be
disregarded for lack of economic substance.
The Tax Court viewed the partnership as essentially a testamentary document. There was
no significant pre-death change, from the standpoint of economic benefit, in the partners’
relationship to the assets. Harper made all decisions, and Michael essentially did what he
was told. The Tax Court noted that Harper contributed nearly all of his assets, and noted
his age, health, and experience as an attorney.
The taxpayer argued that there was a business purpose, to protect the assets from Mrs.
Harper’s creditors. However, the Tax Court said that Mr. Harper’s goal here was to protect
her inheritance, not her existing assets. (The Tax Court never discussed it, but Mr. Harper
could have protected her inheritance from her creditors simply by providing for her in trust
rather than outright.)
The taxpayer cited Church, another case in which the taxpayer paid little attention to
details or formalities. But the Tax Court pointed out that in Church the other partners
contributed property upon the formation of the partnership. The partnership served as the
vehicle for a genuine pooling of interests, and the court concluded that the Church
partnership had been created for a business purpose.
The result was a disaster for the Harper family. The taxpayer not only lost any possible
valuation discount, but all of the partnership assets were still included in the estate at the
value as of the date of death (or alternate valuation date), rather than the date of gift.
But is this case announcing a principle that can be used to undermine all family
partnerships? Or did the taxpayers simply make too many mistakes? If the Tax Court had
simply disregarded the partnership for failure to follow the appropriate formalities, the
decision would have been limited to its narrow facts. Taxpayers could safely avoid the
same result by paying closer attention to the formalities. But by focusing on Section
2036(a), the decision could adversely impact many more taxpayers.
PLANNING:
● Existing Partnerships:
Pay closer attention to the observance of partnership formalities. Since the
Harper Court focused on Section 2036(a) rather than partnership
formalities, there is no guarantee that following partnership formalities will
be sufficient.
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● New Partnerships:
● Observe partnership formalities.
● Younger generation partners should make significant
contributions of capital or services, to support the position
that there is a genuine pooling of interests and a business
purpose
LEICHTER: Estate of Leichter v. Commissioner, T.C. Memo 2003-66; Hall v.
Commissioner, 92 T.C. 312.
RESULT: The Tax Court determined the value of a 100% interest in an S corporation.
It settled on estate tax return value.
FACTS:
After Natalie Leichter’s death, her two sons battled over her estate in the local probate
court so Natalie’s stock (Harlee) was appraised. On audit of Natalie’s federal estate tax
return, the IRS proposed a higher value. At trial, Natalie’s estate argued that it had made a
mistake and the estate tax return value it had used was too high.
Natalie’s estate argued that her estate tax return appraiser significantly overvalued the
Harlee stock, and, in so doing, made the following mistakes:
● Inferred that the appraiser had interviewed Natalie, when he hadn’t.
● Alternated his position as to the ownership of the Harlee stock (one place
stating that Natalie owned the stock, and in another place, stating that
Natalie’s late husband owned the stock).
● Misstated Natalie’s date of death.
● Failed to justify his position that working capital was not excessive.
● Failed to take Harlee liabilities into account.
The Tax Court noted that Natalie’s estate bore the burden of showing “cogent proof” that
its return position, a deemed admission, was erroneous. It held the Estate failed to meet its
burden, stating: While [the errors in the estate tax return appraisal report] might reflect that
[the appraiser’s] appraisal needed proofreading, they do not show that the value is
erroneous.
The Tax Court was impressed with the value decided by the probate referee, and the fact
that the conclusions of value reached by the estate tax return appraiser, the IRS appraiser,
and the probate referee were all within a fairly tight range.
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Mistakes made by estate’s appraisers abound:
● One appraiser had “no viable reason” for claiming “negative goodwill”
(estimated at approximately $1,400,000).
● One report was disregarded as “brief and cursory” (There were less than ten
sentences about the business of the company).
● One estate trial appraiser overly focused on the “willing buyer” but almost
ignored “willing seller.”
IRS trial appraiser used “similar (guideline) comparative companies” that were in fact not
similar to Harlee
Two appraisers for the estate used the wrong valuation date (they got date of death wrong).
PLANNING:
● Appraiser must do due diligence and care.
● Must give appraiser significant factual information about the business.
● Appraiser must really understand nature of business and how it works.
Appraiser must incorporate knowledge of specific business in report.
● Appraiser must get key dates and other facts accurately (Counsel should
check).
● Counsel must demand thoroughness and probity.
● Get it right the first time!
POLACK: Polack v. Commissioner, T.C. Memo 2002-145.
Polack is a case where the Tax Court hoists the taxpayer by the petard of the projections of
his own key employee-manager - a mistake we should be sure not let our own clients
make.
RESULT: The Tax Court held in favor of IRS in its valuation for gift tax purposes of
the non-voting stock of a closely held corporation.
FACTS:
At issue was the valuation for gift tax purposes of gifts of a 52.28% block of the non-
voting stock to the taxpayer's children. Prior to the donation, the taxpayer owned slightly
more than 60% of both the voting stock and non-voting stock. After the donation, he still
owned more than 60% of the common stock.
The key items at issue dealt with projections, and, specifically, the validity and
independence of projections offered by the taxpayer versus those gleaned by IRS's
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appraiser from the corporation's manager in an interview. One projection pertained to the
amount of projected retention of a certain revenue stream. The IRS appraiser based his
estimate solely on what the manager projected, which was in line with the company's past
experience.
The taxpayer projected a far lower amount, stating that he was the most knowledgeable
person regarding that projection. But he didn't offer any factual support for his position that
obviously was less than the company's historical experience.
The Tax Court sided with the IRS appraiser's reliance upon the manager's projection,
finding that the manager had more daily and intimate contact with operations than the
taxpayer did, despite the taxpayer's controlling ownership position, and further that the
manager's projection was more substantiated and much more in line with past performance
than that offered by the taxpayer and on which his appraiser relied without independent
verification.
The second projection in contention was the level of expected future capital expenditures.
There was more controversy as to this projection, as the manager indicated that the IRS's
appraiser had misunderstood him.
Nevertheless, the Tax Court believed the projections as offered by the IRS appraiser to be
more reliable and probative and more in line with the company's operational history than
that offered by the taxpayer.
The taxpayer also complained that his appraiser should have been more readily accepted
than the IRS's appraiser because the taxpayer's appraiser was much more experienced. The
Tax Court turned this complaint aside, noting:
"An expert, no matter how skilled, can only work with the factual record he is given by his
client or obtains through his own efforts. In this case, petitioner's expert relied primarily on
petitioner's unsupported opinion regarding the disputed factual matters."
Query why client didn't give his own appraiser access to the manager that the IRS
appraiser got, or at least access to the same information? The facts certainly seem to be that
the manager was the one who conducted the day-to-day operations of the corporation much
more so than the taxpayer.
The dispute between what the taxpayer meant and what the IRS appraiser thought he meant
should have been resolved with making sure that the only projections offered by the
manager were in writing and very well defined. This can best be controlled by counsel to
the taxpayer being present for any and all interviews with the IRS appraiser.
PLANNING:
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● An appraiser must go beyond blind reliance upon client representations,
especially on critical issues, for the basic information upon which to base a
transfer tax valuation report.
● Appraiser must find and interview personnel in company knowledgeable in
necessary info.
● Client must be willing to provide access to both info and personnel.
DAILEY: Estate of Dailey, TC Memo 2002-301
RESULT: Tax Court awarded reimbursement of litigation expenses to an estate based
on the extent to which the litigation was on the issue of ignoring the existence of family
limited partnership.
The Service litigated both the valuation of the FLP interest and the existence of the FLP.
It has now conceded there was no reasonable basis for disregarding the partnership entity
and to that extant, the estate was entitled to reimbursement.
The court made it clear that to the extent the litigation costs dealt with valuation issues,
there was no right of reimbursement, since the government used a qualified expert.
PLANNING:
● Check to be sure relevant state law met
● Typically FLP status requires activity rather than mere holding of
investment assets, i.e., enterprise or investment for profit
SCHOTT: Schott v. Commissioner, No. 02-70007 (9th Cir. Feb. 18, 2003), rev. and
rem. T.C. Memo 2001-110; Walton, 115 T.C. at 603-04; Cook v. Commissioner, 269 F.3d
854, 858 (7th Cir. 2001); Treas. Reg. § 25.2702-2(a)(5) ; Sections 25.2702-3(b) and (d).
See also R. Coplan, “Seventh Circuit Affirms GRAT Contingent Spousal Annuity Not
Qualified Interest”, The Tax Advisor, January 2002.
RESULT: The 9th Circuit has reversed the Tax Court and held that a two-life annuity
in a grantor retained annuity trust (GRAT) can be valued under Code Section 2702.
FACTS: Patricia A. Schott created a 15-year GRAT with an annual payout of just
over 11% for 15 years.
The GRAT provided that if Pat died during the term, the annuity will be continued to her
spouse for the balance of the term, unless she had revoked the survivor interest.
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Her husband Stephen C. Schott created a substantially identical GRAT.
At issue here is the application of Code Section 2702 to the valuation of retained annuity
interests in transfers to trusts. Code Section 2702 provides, in effect, that for gift tax
purposes, if the grantor retains an interest that is “qualified”, i.e. meets the 2702
requirements, the value of the annuity retained by the donor can be subtracted from the
total value of the amount transferred to the trust. So, if the taxpayer creates an irrevocable
trust and retains a fixed annuity for a term of years, the actuarial value of that annuity can
be subtracted in determining the gift to the other trust beneficiaries.
If the interest retained by the grantor does not meet the definition of a qualified interest,
none of the value of what was kept can be used to reduce the gift tax value of the transfer.
The result is that the entire value what the grantor transferred to the trust will be considered
a gift!
Code Section 2702(b) and Reg. Sections 25.2702-3(b) and (d) provide the definition of the
term Qualified Interest. The examples under subsection (d) include the situation where the
retained interest is an income interest, and the grantor provides a survivor interest to his or
her spouse, which he or she may revoke.
Example 6 under that section makes it clear that is not a qualified interest, since it is an
income interest. However, Example 7 goes on to say:
Example 7. The facts are the same as in Example 6, except that both the term
interest retained by A and the interest transferred to A's spouse (subject to A's right
of revocation) are qualified annuity or unitrust interests. The amount of the gift is
the fair market value of the property transferred to the trust reduced by the value of
both A's qualified interest and the value of the qualified interest transferred to A's
spouse (subject to A's power to revoke). The distinction is between pure income
and an annuity, a systematic liquidation of principal and interest over a specified
period of time.
On the face of it, the annuity in this case should qualify. However, the IRS argues that the
survivor annuity to the spouse is contingent on the spouse being alive at the death of the
grantor; therefore the spouse’s interest is “contingent” and cannot be considered a qualified
interest.
The Tax Court, at T.C. Memo 2001-110, sustained the IRS position that the two-life
annuity could not be valued under Code Section 2702. But the 9th Circuit had no problem
reversing this decision. It held that the facts here fit neatly into those of Example 7, and
that the statute and regulations do not prohibit the valuation of a “contingent” interest.
In reaching this conclusion, the 9th Circuit distinguishes the decision in Cook. The facts of
the Cook case are very similar to those in this case, except the trust in Cook required the
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parties be married on the date the survivor annuity commenced. The 9th Circuit held that
this is a contingency that eliminates the qualification of the survivor annuity.
The 9th Circuit concludes:
On the face of it, the Schotts' trusts fit within Example 7 and are therefore qualified
and deductible from the value of their gifts. The annuity in each Schott trust is a
fixed percentage of the capital to the grantor for life, then to the grantor's spouse,
with a fixed termination of fifteen years if the grantor and spouse live that long. A
two-life annuity table makes the value of the gift ascertainable. The value of the
grantor's power to revoke is treated as the retention of a qualified interest as
specified in Treas. Reg. § 25.2702-2(a)(5).
PLANNING:
● This decision implies that the Regulations specifically permit the use of the
two-life GRAT.
● If you are not in the 9th Circuit, you are faced with the Cook decision. Is
there a conflict between the 7th and 9th Circuit that could cause this issue to
get to the Supreme Court?
● Note the 9th Circuit did not specifically disagree with Cook, distinguishing
it on the basis of the requirement in Cook that the parties be married at the
date the survivor annuity begins.
● Do not include conditions such as marital status to the requirement of the
survivor annuity
● Not everyone agrees that this decision is correct.
● If you are not in 9th Circuit, go slow. Not safe to reduce value of the gift on
creation of a GRAT to take into consideration the revocable spousal
interest.
KERR: Kerr v. Commissioner, (Fifth Cir., 2002) affirming 113 TC # 30., IRC. §
2704(b)(2)(A), (2)(B), & (3)(B); Treas. Reg. § 25.2704-2(b).
RESULT: In yet another Fifth Circuit opinion, the court upheld the Tax Court.
At issue was the valuation of gifts of limited partnerships interests to grantor retained
annuity trusts (GRATs). The appellate court agreed with the government and Tax
Court in holding that transfers to a GRAT were gifts of limited partnership interests,
not assignee interests. Discounts for lack of control and marketability could be
applied, however, because IRC §2704(b) didn't apply, and restrictions of liquidation
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of the partnerships could be considered for valuation purposes. Restrictions on
liquidation contained in the partnership agreement did not constitute "applicable
restrictions" within the meaning of Code Section 2704(b).
FACTS: The taxpayers and their children formed two interrelated family limited
partnerships, under Texas law, KIL and KFLP. They made capital contributions to both
partnerships.
The interests were allocated so that in KFLP, taxpayers and their children were general
partners, and the taxpayers were also Class A and Class B limited partners. In KIL, KFLP
was the general partner; taxpayers were Class A limited partners; and KFLP, taxpayers,
and their children were Class B limited partners.
The taxpayers subsequently transferred Class A limited partnership interests in KFLP and
KIL to the University of Texas, and the KIL partnership agreement was amended to admit
UT as a Class A limited partner.
After making the charitable gifts, the taxpayers made various gifts of Class B limited
partnership interests to their children and to grantor retained annuity trusts, claiming
substantial valuation discounts for lack of marketability.
The valuation of the transfers to the GRATs was at issue here.
The IRS rejected the taxpayer’s discounts, arguing that both partnership agreements'
restrictions on the right to liquidate constituted "applicable restrictions" within the meaning
of Code § 2704(b).
An "applicable restriction" on liquidation in a partnership agreement, to the extent that it is
more restrictive than state partnership law, is disregarded under Code § 2704(b) in valuing
the transferred interests.
The Commissioner also contended that the KFLP interests assigned to the GRATs were
equally subject to § 2704(b) because in truth they were partnership interests.
In valuing the gifts, the taxpayers contended that:
● What they transferred were assignee interests not limited partnership
interests.
● That IRC §2704(b) did not apply
The Tax Court summarily found for the taxpayers, holding that, on the first issue, the
transferred interests were partnership, not assignee, interests.
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The restrictions in the partnership agreements, which are essentially identical in both
partnerships, provide that the partnerships will dissolve and liquidate on the earlier of
December 31, 2043, by agreement of all the partners, or on the occurrence of certain
narrowly defined acts of dissolution.
The agreement also provides that that no limited partner shall have the right to withdraw
from the partnership before it dissolves and liquidates, and also provides a right of first
refusal for Class B limited partners.
According to the Fifth Circuit, the characteristics of "applicable restrictions" under the
2704(b) applicable in this case are that they:
● Effectively limit the ability of the partnership to liquidate,
● Either lapse or the restriction can be removed by the family after the
transfer,
● Are more restrictive than State law.
Noting that the Tax Court did not consider the issue, the Fifth Circuit held that under Texas
law the family could not unilaterally remove the restrictions because the agreement of a
charity, the University of Texas, would be required. Having found that the second
requirement above for application of IRC §2704(b) did not apply, the appellate court did
not rule on the other issues. However, it agreed with the Tax Court that the interests
transferred were to be valued as partnership rather than assignee interests.
The Fifth Circuit agreed with the Tax Court that restrictions on liquidation in the
partnership agreement were not applicable restrictions under IRC §2704(b). However, the
basis for its conclusion could be troubling.
The Fifth Circuit opinion refers to what it considers a "defining feature' of IRC §2704(b) –
that it only applies if the restrictions could be removed by family members. It focused on
the fact that restrictions on liquidation of the partnership could not be removed exclusively
by family members in this case, since partnership interests were owned by the University
of Texas, clearly not a family member. It pointed out that the restrictions in the partnership
agreement related both to the liquidation of the entity itself, and also to the withdrawal of
any partner.
Note that the Tax Court took a totally different approach in determining restrictions of
liquidation of the partnership under the partnership agreement were not applicable
restrictions. In the Tax Court opinion, Judge Jacobs concluded that the liquidation
provisions in the partnership agreements was no more restrictive than the limitations that
apply generally to partnerships under Texas law. Therefore, under Reg § 25.2704-2(b), the
partnerships' dissolution and liquidation provisions were not "applicable restrictions." In
fact, since the Tax Court determined the restrictions on liquidation of the partnership in the
agreement were no greater than those imposed by state law, it specifically refused to
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consider alternate contentions, including the argument that the restrictions cold not be
removed exclusively by family members.
The result in Kerr is positive. But the concern is that Kerr may be distinguishable from
other FLP cases where all interests are owned entirely by family members, which is the
case for most family limited partnerships and LLCs. In other words, was Kerr successful
only because a legitimate outsider blocked it from unilaterally removing restrictions? Will
the government argue that the application of Kerr is limited to family partnerships and
LLCs in which non-family members are partners or members?
The broad Tax Court concludes that restrictions on the liquidation of the entire entity
which are no broader than state law may have been narrowed by the Fifth Circuit. Of
course, the appellate court did not disagree with the Tax Court on the 2704(b) issue; it
simply pursued a different theory.
PLANNING:
● Most states have amended their partnership and LLC laws to expressly
provide for restrictions similar to those in the Kerr case.
● Consider making a charity a legitimate and real partner/member.
DUNN: Estate of Dunn v. Comm., 2002 TNT 151-6, (5th Cir. 2002), rev'g, T.C.
Memo 2000-12,
RESULT: The 5th Circuit held that the built-in gains tax liability of a corporation's
assets must be considered as a dollar-for-dollar reduction when calculating its asset-based
value and that if an asset-based valuation approach is used, it must be assumed the
corporate assets will be sold, and a capital gains tax paid.
The Court also suggested IRC §7430 would apply.
FACTS: This involved the valuation of an operating company. The IRS valuation
team tried to advocate a valuation based entirely on asset value (with no reduction for
built-in tax liability and no weight given to income-based value).
The IRS appraiser provided no documentation for the value it proposed.
PLANNING:
● The built-in tax liability of a corporation provides a readily ascertainable
dollar for dollar reduction in value for gift, estate, and GST tax purposes.
- 17 -
GRANT: Estate of Constance R. Grant v. Commissioner; No. 00 4066 , June 21, 2002
IRC Sec. 2053; Estate of Constance R. Grant v. Commissioner, T.C. Memo. 1999 396;
Reg. Sec. 20.2053 3(a). Estate of Millikin v. Comm'r, 125 F.3d 339, 344 (6th Cir. 1997);
Estate of Love v. Comm'r, 923 F.2d 335, 337 38 (4th Cir. 1991); Marcus v. DeWitt, 704
F.2d 1227, 1229 30 (11th Cir. 1983); Hibernia Bank v. United States, 581 F.2d 741, 744 46
(9th Cir. 1978); Pitner v. United States, 388 F.2d 651, 659 (5th Cir. 1967). Estate of Love,
923 F.2d at 337 38; Hibernia Bank, 581 F.2d at 746.
RESULT: The Second Circuit of Appeals held an estate must base deductible
executor's fees on the size of the probate estate rather than the (often much larger)
combined size of the “expanded estate” (probate plus revocable trust). The Court also held
that to be deductible, the executor’s fees must meet both federal and state requirements.
This is a case of first impression.
FACTS: In 1991, Constance Grant conveyed most of her property to a trust. The
trust provided that the property would be distributed to her two children upon her death.
In 1994, she died. Her children were her sole heirs and personal representatives.
In December 1994, Mrs. Grant’s estate filed a federal Estate Tax Return valuing the estate.
The return listed about $11,000 in probate assets and almost $900,000 in trust assets.
Her estate claimed administration expenses of $48,102, which included $16,875 in
personal representatives' fees.
Three years later, the IRS issued a deficiency notice. The Service stated that the estate
owed additional tax because the personal representatives' fees, as well as some other
administrative expenses, were not deductible in the amount claimed. The estate petitioned
for a re-determination.
The Tax Court held that the Code (Section 2053) and Maryland law provided a personal
representative’s fee deduction only for services performed on behalf of the probate (i.e. the
non trust) portion of the estate. (It did allow trustee’s commissions on trust assets). The
court also limited the amount of miscellaneous expenses that could be deducted by the
estate because most of the expenses claimed were not necessary to administering assets in
the probate estate.
The deduction for personal representative’s fees was cut down to a mere $1,012.77! The
Tax Court did allow another $5,720 in trustees' commissions, and $3,100 in additional
administrative expenses. This drastic reduction in allowable deductions was then appealed
by the estate.
This case concerns the proper interpretation of Code Section 2053 as it relates to the
deduction of costs for administering an estate.
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The question raised here was simple:
● In order to be deductible, must an administration expenses meet the
requirements of BOTH state and federal law?
● Or is it sufficient for a federal estate tax deduction that the expense be
allowable under state law?
The Tax Court found - and the Court of Appeals agreed - that it was not enough for the
personal representatives' fees simply to be allowable under state (here Maryland) law. The
fees, to be deductible, must ALSO meet Code Section 2053's requirements.
Section 2053 allows for deductions for administration and certain other expenses "as are
allowable by the laws of the jurisdiction . . . under which the estate is being administered."
Administration expenses are defined in the Regs as expenses actually and necessarily
incurred in the administration of the decedent's estate. Note, however, that the Regs further
limit this definition:
"[t]he expenses contemplated in the law are such only as attend the settlement of
an estate and the transfer of the property of an estate to individual beneficiaries or
to a trustee.”
Some circuits have concluded that finding an expense allowable under state law is simply a
threshold requirement that must be satisfied before considering section 2053's federal
requirements for allowability.
Certainly, to be deductible, the expense must be:
(1) "Necessary,"
(2) For the benefit of the estate rather than for the beneficiaries, and
(3) Be a result of the transfer of property.
The Second Circuit had never grappled with the issue of whether allowability under Code
Section 2053 rests on meeting BOTH state law and federal law requirements. Years ago
(1975), the Smith Estate case, the Court had agreed that the allowability of an expense
under Code Section 2053 is "ultimately a question of federal law and that "federal courts
cannot be precluded from re-examining a lower state court's allowance of administration
expenses to determine whether they were in fact necessary to carry out the administration
of the estate [.]"
In Grant, the Appeals Court held explicitly that - in order for an expense to be deductible
under Code Section 2053, it must qualify as an "administration expense" under BOTH the
applicable state law AND the federal law as set out in the Regs.
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Most of the time spent by the personal representatives was - according to the Tax Court’s
findings - devoted to handling the trust assets rather than the estate’s probate property.
(Remember that the trust assets passed to the beneficiaries by operation of law - not by an
action of the personal representatives. And the time they spent on trust assets did not
qualify as "necessary" for the administration of the estate).
Of course, the federal estate tax is - technically - a tax on the transfer of property at the
estate owner’s death. So by conveying the bulk of her assets through a trust rather than by
will or intestacy, according to the Appeals Court, “Grant limited the amount of her
property that was transferred in her estate and consequently limited the estate's tax
deduction for administration expenses.”
The Appeals Court felt that the Tax Court’s decision to allow the maximum amount of
personal representatives' fees based on the value of the estate assets as well as the
maximum amount of trustees' fees based on the value of the trust assets was an appropriate
determination.
With certain highly limited exceptions (e.g. costs incurred in collecting life insurance
proceeds or expenses incurred in settling title to joint property included in the gross estate),
deductible administration expenses include ONLY those incurred in the collection and
preservation of PROBATE assets (as well as the payment of estate debts and the costs of
distributing the PROBATE assets to the estate’s beneficiaries).
PLANNING:
● Keep meticulous records showing the “time spent” breakdown
MARITAL DEDUCTION
DAVIS: Estate of Ralph H. Davis, et al. v. Commissioner; T.C. Memo. 2003-55; No.
210-02, February 28, 2003; IRC Secs. 2001 , 2051 , 2056 (b)(5) and (7) ; Reg. Sec.
20.2056(b)-5(a)(1); Estate of Armstrong v. Commissioner, 119 T.C. 220 (2002); Estate of
Clack v. Commissioner, 106 T.C. 131, 137 (1996); Estate of Doherty v. Commissioner, 95
T.C. 446 (1990), rev’d. on other grounds 982 F.2d 450 (10th Cir. 1992);
RESULTS: No estate tax marital deduction was allowed to an estate for the
property passing to an amended trust. Because of limitations on the right of the
surviving spouse to trust income, and limitations on her power to consume or appoint
principal, the trust did not qualify for the federal estate marital deduction. The court
concluded that the surviving spouse’s power to invade trust principal was not
exercisable in all events, and, accordingly, not a qualifying power of appointment.
- 20 -
FACTS: Davis was survived by his wife, and two daughters. Davis’s will “poured over”
the residue of his estate to a self-trusteed revocable living trust. Evelyn, his surviving
spouse, was designated as successor trustee.
At the time of his death, this testamentary pour over trust, as amended, provided:
“After the death of trustor survived by his spouse and during the lifetime of his
surviving spouse, the trustee shall pay to or apply for the benefit of the surviving
spouse, in quarter annual or more frequent installments, all of the net income from
the trust estate as the trustee, in the trustee's reasonable discretion, shall determine
to be proper for the health, education, or support, maintenance, comfort and
welfare of grantor's surviving spouse in accordance with the surviving spouse's
accustomed manner of living.”
“Guideline -- Other Sources: Beneficiary: In making distributions to grantor's
surviving spouse, the trustee, in her reasonable discretion, may consider any other
income or resources of the beneficiary known to the trustee and reasonably
available.”
“Invasion of Principal for Surviving Spouse -- Narrow Standard: If the trustee shall
determine that the income from this trust and that the income and principal from
the surviving spouse's own trust shall be insufficient to maintain surviving spouse's
health, support, and maintenance, the trustee may, after surviving spouse has
exhausted all assets of her own trust, invade the principal of this trust for the
benefit of surviving spouse, in the trustee's reasonable discretion.”
Generally, a "terminable interest" (an interest in property that will terminate or fail on the
lapse of time, on the occurrence of an event or contingency, or on the failure of an event or
contingency to occur) will not qualify for a marital deduction. Stated in another way, for a
transfer of assets to qualify for the federal estate tax marital deduction, the interest of the
surviving spouse in such assets may not terminate on her death or other event and then
pass to other beneficiaries.
In this case, the interest of the surviving spouse is by definition a terminable interest and it
is distributable to other beneficiaries, the couple’s daughters, on the death of the surviving
spouse.
There are exceptions to the general rule that a terminable interest will not qualify for the
martial deduction: Even if a surviving spouse is given a life estate (by definition a
terminable interest), it will still qualify for the estate tax marital deduction if the life estate
is coupled with a general power of appointment. More specifically, an interest – even if
terminable – will still qualify if the interest passing from the decedent gives the surviving
(U.S. citizen) spouse all the income from the entire interest for life (or all the income from
a specific portion), and it is payable annually or more frequently, and the surviving spouse
has the power to appoint the entire interest (or the specified portion) and she can exercise it
for herself, or her estate and no one else has the power to appoint any part of the interest,
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or the specific portion, to any one other than the surviving spouse. This presumes the
spouse’s power of appointment can be exercised during her life or at death – by that spouse
– alone and in all events.
Note that this exception requires that the surviving spouse must be entitled to all of the
income from the trust (or from a specific portion thereof) for life and also have a general
power of appointment over trust’s assets.
To reiterate, for a life estate coupled with a power of appointment to qualify for a marital
deduction, it must meet the following five tests:
1. The surviving spouse must be entitled for life to all the income from the
entire interest or to all the income from a specific portion.
2. The income must be payable annually or more frequently.
3. The surviving spouse must have a power to appoint the entire interest or the
specific portion to either herself or her estate.
4. The entire interest (or the specific portion) must not be subject to a power in
any other person to appoint any part to anyone other than to the surviving
spouse.
5. The surviving spouse’s power (whether exercisable by will or during life)
must be exercisable by her alone and in all events.
The law of jurisdiction under which the interest passes will be applied for purposes of
determining the interests passing to a surviving spouse. Here, that state is California and
therefore that state’s law was applied. In essence, it provides that the intent of a testator is
found by examining the document as a whole.
"The paramount rule in the construction of wills, to which all other rules must
yield, is that a will is to be construed according to the intention of the testator as
expressed therein, and this intention will be given effect as far as possible."
"Whether the will contains a marital deduction gift depends upon the intention of
the testator at the time the will is executed."
“A marital deduction gift is a transfer that is intended to qualify for the marital
deduction. Accordingly, we inquire whether decedent evinced the intention that the
property transferred to his testamentary trust would qualify for the marital
deduction.”
Here, the court looked at the amended trust which provides that the trustee shall
pay:
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“all of the net income from the trust estate as the trustee, in the trustee's
reasonable discretion, shall determine to be proper for the health,
education, or support, maintenance, comfort and welfare of grantor's
surviving spouse in accordance with the surviving spouse's accustomed
manner of living.”
The problem is that a reading of this provision leads to the conclusion that the surviving
spouse's right to receive income is significantly restricted. In determining the appropriate
amount of income to distribute to the surviving spouse, the trustee is required to consider,
in the trustee's reasonable discretion, the surviving spouse's health, education, support,
maintenance, comfort, and welfare, in light of her accustomed manner of living.
Note also that the phrase, "in accordance with the surviving spouse's accustomed manner
of living" modifies and limits the expression that precedes it: "all of the net income from
the trust estate as the trustee, in the trustee's reasonable discretion, shall determine to be
proper for the health, education, or support, maintenance, comfort and welfare".
This "usual and customary standard of living" clause was interpreted to mean that the
surviving spouse does not have (as is required to qualify for the marital) such "command
over the income that it is virtually hers".
This problem is made worse by the fact that the trustee, in exercising reasonable discretion,
may consider "any other income or resources of the beneficiary known to the trustee and
reasonably available." Together, these provisions prevent the surviving spouse from being
entitled to the entire income from the trust.
Nor is there language in the amended trust which explicitly refers to Mr. Davis’s desire to
obtain a marital deduction.
The court therefore determined that the decedent did not intend to grant the surviving
spouse the entire income interest for life.
A power will not be considered to be a power exercisable by a surviving spouse alone and
in all events if the exercise of the power requires the joinder or consent of any other person
or if there are any restrictions (either by the terms of the instrument or under applicable
local law) on the exercise of a power to consume property (whether or not held in trust) for
the benefit of the spouse.
EXAMPLE: Assume a surviving spouse’s power of invasion is exercisable only for the
spouse's support or only for her limited use. The IRS would claim the power is not
exercisable in all events.
In order for a power of invasion to be exercisable in all events, the surviving spouse must
have the unrestricted power, exercisable at any time during her life, to use all or any part of
- 23 -
the property subject to the power, and to dispose of it in any manner, including the power
to dispose of it by gift (whether or not she has power to dispose of it by will).
In deciding whether a trust creates a power of appointment over the entire interest, the
courts will consider whether the trust documents created a general power of appointment
under state (in this case California) law. Unless the language used by the testator in
creating the trust creates an unambiguous general power of appointment, "the
ascertainment of the breadth of the trustee's power is to be ascertained with reference to the
intent of the trust's creator."
The use of an ascertainable standard makes a power limited rather than general in
California. A power of appointment that is limited by an ascertainable standard relating to
the person's health, education, support, or maintenance is not a general power of
appointment. Yet in the Davis Trust, invasion of the trust’s principal is permissible only if
the trust’s income is insufficient to provide for the surviving spouse's health, support and
maintenance. The trustee may only invade principal for the surviving spouse's health,
support, and maintenance. The very wording of the amended trust, "Invasion of Principal
for Surviving Spouse-Narrow Standard" indicated to the court that Davis did not intend to
provide his surviving spouse with an unrestricted power of appointment.
The estate had argued that under the trust sections quoted above, the surviving spouse had
such a power, particularly since she was the trustee of the trust.
Siding with the IRS, and citing several state and federal authorities, the Tax Court held the
trust did not qualify under the life estate/power of appointment section. Referring to
Section Two quoted above, the court found the income interest of the surveying souse in
the trust was significantly restricted. As noted above, by limiting the spouse’s right to
income to that required for her “accustomed manner of living”, she did not have an
absolute right to all trust income annually. The fact she was the trustee was not relevant,
since she might be disqualified under a variety of circumstances.
The court points out that the trust also fails the requirement that the surviving spouse have
an unqualified power to appoint trust principal to herself or her estate. Even if the trust
flunks the “all income for life” requirement, if the spouse had an absolute and unlimited
right to invade the trust at any time, that would be the equivalent of the right to all income
for life. In this regard, the Tax Court considered applicable state law, in this case
California, and concluded that the power of appointment would not qualify as “general”
under state law. It also pointed out that the required power for marital deduction purposes
under Code Section 2056(b)(1)(5) is narrower than that applied under Code Section 2041.
The Tax Court also briefly considered and then dismissed the possible application of the
QTIP rule (Code Section 2056(b)(7)). While that section does not require the surviving
spouse to have any power of appointment over the trust principal, the income interest of
the spouse must be exactly the same as under the general power of appointment exception.
- 24 -
California - and some other states - has adopted marital deduction “savings” provisions
intended to permit the reformation of a trust to qualify for the marital deduction where it is
defective, as in this case. If the intent to create a marital deduction gift can be established,
the trust could be “conformed” to qualify under the very liberal provisions of Cal Probate
Code Section 215227.
Applying California law, as noted above, the Tax Court determined that the decedent’s
intent that the transfer qualify for the marital deduction is determined at the “time the will
is executed”. Cal Probate Code §§1030(d), 1032(a). The intent to qualify for a marital
deduction is required for any relief from defects under California law. Cal Probate Code
§21520
But the court found that the language limiting the income interest of the surviving spouse
in the trust was inconsistent with a claim the trust was intended to qualify for the marital
deduction. Nor was there specific – or even indirect - reference to such intent in the
documents.
Long after the federal estate tax return was filed, and the marital deduction disallowed, the
surviving spouse made a last ditch attempt to “save” he marital deduction by exercising an
“Irrevocable Exercise of General Power of Appointment” under which she claimed an
irrevocable right to all of the trust income after the death of her husband. The court, as
noted above, held she did not have an unlimited power of appointment over any part of the
trust.
PLANNING:
● Use Davis to review and create quality-control checklist of marital
requirements.
● Insert marital deduction “intent and savings clause”
DOMICLE ISSUES
JACK: Estate of Robert A. Jack, et al. v. United States; No. 01-410T November 27,
2002; IRC Secs. 2001 ; 2031 ; 2101 ; 2106 ; Toll v. Moreno, 458 U.S. 1 (1982) ; Anwo v.
INS, 607 F.2d at 437,438 (D.C. Cir. 1979) ; Elkins v. Moreno, 435 U.S. at 651 ; United
States-Canada Free Trade Agreement, Pub. L. No. 100-449, 102 Stat. 1851 (1988);
Carlson v. Reed, 249 F.3d 876 (9th Cir. 2001).
RESULT: The Federal Court of Claims granted the IRS's motion for a partial
summary judgment to determine whether Dr. Jack, a Canadian citizen employed in
- 25 -
the United States on the date of his death, admitted to the United States under non-
immigrant, temporary professional classifications, was legally capable of forming an
intent to be domiciled in the United States for federal estate tax purposes. His original
visa allowed for the temporary entry of certain types of Canadian professionals under
the United States-Canada Free Trade Agreement of 1988. NOTE: This "TC" status
no longer exists and has been replaced by "TN Temporary Professional" status).
The estate had argued that the intent to establish domicile by the holder of a TN
Temporary Professional visa would be in direct violation of the terms of the visa and
therefore such intent would be impossible to have. But the IRS claimed that the
holder of a TN Temporary Professional visa is legally capable of forming the intent to
be domiciled in the United States for federal estate tax purposes.
FACTS: Dr. Robert Jack, a veterinarian, was born in Canada in 1947 and died in
California in 1996.
Until 1992, Dr. Jack lived and was domiciled in Canada.
In October of 1992, Dr. Jack was offered a two-year employment contract with the
University of California as Equine Medical Director in its School of Veterinary Medicine.
In November of that year, Dr. Jack applied for admission to the United States as a TC class
non-immigrant and obtained TC Temporary Professional status, allowing him to be
admitted to, and remain in, the United States for a period of one year. The next month, he
moved to Davis, California, under his TC Temporary Professional visa, and in January,
1993, started as Equine Medical Director of the School of Veterinary Medicine.
During the time he lived in California, Dr. Jack maintained bank accounts in Canada,
continued affiliations with Canadian professional associations, remained a licensed
Canadian veterinarian, maintained his Canadian driver's license and voter registration, and
also maintained a Canadian mailing address.
In the middle of December of 1993, Dr. Jack's visa was extended - until the end of 1994.
The following year, he obtained Temporary Professional classification available under the
newly-enacted NAFTA, enabling him to continue his employment in the United States.
In 1995, Dr. Jack extended his contract with UC Davis for two years, through the end of
December, 1996 - which enabled a further extension of his TN Temporary Professional
visa through November 17, 1996. But only three months later, on August 27, 1996, Dr.
Jack died in Davis, California, at age 49.
Dr. Jack's executor paid an estate tax of $15,415.00, as a non-resident not a citizen of the
United States, based on the value of his gross estate in the United States. That tax did not
include any assets he owned outside the United States at the time of his death.
The estate tax return was audited; a Notice of Deficiency was issued by the IRS - assessing
an estate tax deficiency in excess of $80,000 based on a determination that Dr. Jack was
- 26 -
domiciled in the United States on the date of his death. So "the reported value of the
taxable estate is increased by the entire value of the gross estate outside the U.S. pursuant
to Section 2031 of the Internal Revenue Code." By the end of 2000, the IRS had assessed
the estate $80,443.00 in additional estate taxes, plus almost $24,000 in interest. This was
paid and then the estate's executrix filed an amended United States Estate Tax Return
claiming a refund of estate taxes of $85,497.00.
Both the IRS and the Estate then filed cross-motions for partial summary judgment
regarding whether an individual holding a TN Temporary Professional visa can legally
form the intent to be domiciled in the United States, thus subjecting the individual's foreign
property to U.S. federal estate tax.
"A lawful permanent resident is an individual who, in accordance with immigration law,
has been granted the privilege of residing permanently in the United States." But even if a
person from a foreign country has only a non-immigrant visa, he or she could be
considered to have the intent to remain here indefinitely and therefore be a domiciliary for
purposes of imposing a federal transfer tax.
A person will be considered a U.S. resident for federal estate tax purposes only if he or she
is considered to be "domiciled" here. That means a person is a non-resident alien for estate
tax purposes if he or she does not intend to remain in the U.S. indefinitely. Domicile
requires a subjective test but ultimately is determined by the examination of objective
factors that are used to ascertain the person's "intent."
For adults, domicile is established by physical presence in a place in connection with a
certain state of mind concerning one's intent to remain there." Domicile is "a residence at a
particular place accompanied with positive or presumptive proof of an intention to remain
there for an unlimited time."' Generally, "the domicile of an individual is his true, fixed and
permanent home and place of habitation. It is the place to which, whenever he is absent, he
has the intention of returning."
"A domicile once acquired is presumed to continue until it is shown to have been changed.
Change of domicile occurs where there is a change of abode coupled with "the absence of
any present intention to not reside permanently or indefinitely in the new abode,"' as
opposed to entertaining a "floating intention" to return at some time in the future.
"Where a change of domicile is alleged, the burden of proving it rests upon the person
making the allegation. To constitute the new domicile, two things are indispensable: First,
residence in the new locality; and, second, the intention to remain there. . . . Either without
the other is insufficient. Mere absence from a fixed home, however long continued, cannot
work the change. There must be the animus to change the prior domicile for another. Until
the new one is acquired, the old one remains."
Domicile is determined under state law and is usually based on the jurisdiction with which
an individual has the most significant contacts. Officials will examine many factors to
determine intent. Among them are
- 27 -
● Size, nature, and location of residences (including those of family
members).
● Days spent here in U.S.
● voting registration,
● place of business,
● filing of income tax returns,
● automobile registration,
● driver's license,
● social security information,
● credit cards,
● passport, bank and brokerage accounts,
● registration of personal property such as cars, boats, and plans,
● club and religious memberships, and (given less credibility because they are
self-serving but still factors that are examined)
● declarations of domicile and recitations in wills or deeds of trust.
The courts will decide each domicile case on its own particular facts.
"A "resident" decedent is a decedent who, at the time of his death, had his domicile in the
United States. . . . A person acquires a domicile in a place by living there, for even a brief
period of time, with no definite present intention of later removing therefrom. But
residence without the requisite intention to remain indefinitely will not suffice to constitute
domicile.
The IRS claims that Dr. Jack developed the subjective intent to stay in the U. S. despite the
fact that such intent would have been in direct violation of his visa, and that; therefore, the
IRS should be allowed to tax Dr. Jack's property holdings outside of the U.S. The Service
argues it should not be prevented from demonstrating that Dr. Jack either failed to reveal
his true intent to stay in the United States indefinitely to the immigration officer who
granted him his renewed TN Temporary Professional visa in 1996, or that he had
developed the intent to stay in the United States in the intervening months between the
renewal of his 1996 TN Temporary Professional visa and the time of his death.
The estate argues that the basic terms of the doctor's TN Temporary Professional visa
required him to retain his Canadian domicile and, therefore, prevented his ability to
develop the requisite intent to stay in the United States, since the TN Temporary
Professional visa specifically prevents such domiciliary intent. But the Court noted that -
even though the TN visa raises the presumption that Dr. Jack's domicile never changed
from Canada, it did not address the issue of whether Dr. Jack could have been in the
United States in violation of his visa.
Originally, Dr. Jack entered the United States as a Canadian citizen with Temporary
Professional status. But later, after NAFTA, Dr. Jack's non-immigrant status was converted
to the TN Temporary Professional classification. NAFTA provides that the U. S., Canada
- 28 -
and Mexico shall grant temporary entry to certain classes of business people seeking to
"engage in business activities at a professional level. . . ." and states,
"An alien who is a citizen of Canada or Mexico . . . who seeks to enter the U.S. under ...the
provisions of ...NAFTA . . . to engage in business activities at a professional level as
provided for ...may be admitted for such purpose under regulations of the Attorney
General. . . . For purposes of this Act, including the issuance of entry documents . . . such
alien shall be treated as if seeking classification, or classifiable, as a non-immigrant. . . .
This has been defined to mean entry without the intent to establish permanent residence.
The alien must satisfy the inspecting immigration officer that the proposed stay is
temporary, i.e., that the stay has a reasonable, finite end that does not equate to permanent
residence. "In order to establish that the alien's entry will be temporary, the alien must
demonstrate to the satisfaction of the inspecting immigration officer that his or her work
assignment in the United States will end at a predictable time and that he or she will depart
upon completion of the assignment."
A Canadian citizen who qualifies for admission may be admitted for up to one year under
the TN classification symbol which can be extended for additional one-year periods. There
is no limit on the number of extensions a Canadian citizen may obtain to remain in the
United States on such status as long as the individual does not intend to remain in the U.S.
permanently.
There are cases which hold that aliens who are in the U.S. under a valid nonimmigrant visa
can develop the subjective intent to remain here indefinitely and, therefore, can legally
establish domicile. Clearly, Congress did not specifically limit the ability of certain visa
holders to establish legal domicile - while in other cases - particularly for many . . . non-
immigrant categories, Congress specifically precluded the covered alien from establishing
domicile in the U.S.
To my knowledge, there are no cases that hold that any non-immigrant visa holder,
regardless of the type of visa classification held, can - or cannot - establish domicile. In
two cases, Elkins v. Moreno and Toll v. Moreno, the Ninth Circuit addressed the issue of
whether a TN/TD Temporary Professional visa holder can form the intent to establish
domicile in the United States. There, the issue was whether a person holding a TD visa can
"possess the legal capacity to establish domicile in the U.S. under federal immigration
law." The courts held that the holder of such a visa did not have the capacity to establish
domicile.
But in both cases, when Congress established the visa program in question, "admission into
the United States for TN/TD non-immigrant aliens was expressly conditioned on intent not
to establish permanent residence here and therefore held that Congress has precluded such
visa holders from establishing domicile in the United States. Under those laws, the
government retains the right to review the status of an alien to determine if the alien is in
compliance with the terms of his visa and deport aliens for violating the terms of their visa.
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The IRS has previously determined that an illegal alien can establish domicile in the
United States. This made it possible to tax all assets in the alien's estate, both inside and
outside the U.S. upon the alien's death.
Here, the IRS is saying that it should be allowed to attempt to show that Dr. Jack was in
the United States in violation of his visa at the time of his death, that it should be permitted
to prove that - even though he swore when admitted to the U.S. that his stay was temporary
- that his intent changed, or was other than what he represented to the INS officers who
stamped his passport."
In its Notice of Deficiency, the IRS determined that "the decedent was domiciled in the
United States on the date of death." “Such an assessment is entitled to a legal presumption
of correctness and according to this court, the "government should be allowed an
opportunity to prove, consistent with the notice of deficiency and the assessment, that Dr.
Jack had developed the intent to domicile in the United States, even though in violation of
the terms of his visa at the time of his death."
The purpose of a summary judgment is to dispense of the need for the parties to undertake
the time and expense of a trial where it is clear that the moving party should prevail
without further proceedings. But if sufficient evidence is shown which raises a question as
to the outcome of the case, the motion for summary judgment should be denied.
Summary judgment is allowed if the evidence shows there is no genuine issue as to any
material fact (one which would make a difference in the result of the case under the
governing law). The court is determining whether or not there is a genuine issue and
whether the evidence presents a disagreement sufficient to require submission to fact
finding, or whether the issues presented are so one-sided that one party must prevail as a
matter of law.
Here, both the IRS and the estate agree that Dr. Jack held a TN Temporary Professional
visa at the time of his death.
The Court of Claims found that Dr. Jack may have developed the intent to be domiciled in
the United States although that would have put him in violation of the terms of his visa and
that the IRS has raised enough of an issue regarding Dr. Jack's domiciliary status at the
time of his death to be allowed an opportunity to establish that Dr. Jack had formed the
intent to be domiciled in the U.S. at the time of his death for the purposes of assessing
estate taxes.
PLANNING:
● Ask about and reconfirm with EVERY client and spouse their citizenship –
and domicile intentions
● Become conscious of the traps - and planning opportunities - for those who
are not U.S. citizens or domiciliaries.
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GIFT TAX ISSUES
COSTANZA: Estate of Duilio Costanza, et al. v. Commissioner; 2003 FED App. 0055P
(6th Cir.); No. 01-2207 ; February 19, 2003 ; Estate of Duilio Costanza v. Commissioner,
T.C. Memo. 2001-128; Estate of Moss v. Comm'r, 74 T.C. 1239, 1247 (1981) (upholding
the validity of a SCIN).
RESULTS: The Sixth Circuit held that a sale of SCINs was a bona fide sale of
property. It remanded the case back to the Tax Court to ascertain if any portion of
the SCIN was a “bargain sale” and therefore partially a taxable gift.
FACTS: This “rags-to-riches” story began when Duilio Costanza was born in Italy in
1919. Costanza came to the United States and worked as a welder for General Motors.
When he retired in 1966, Costanza opened an Italian restaurant on property he owned in
Flint. He later built a small office plaza on nearby property that he also owned. Both
properties were appraised in 1991 at a value of $830,000.
Longing for his homeland, in October of 1992, 73 year old Costanza decided to return to
Italy and sell his Flint properties. His attorney suggested he sell the restaurant and
properties to his son Michael in exchange for a SCIN (Self-Canceling Installment Note –
an installment note cancelable upon death of the lender).
In late December of 1992 or early January of 1993, Michael signed the SCIN for $830,000.
He signed a mortgage fully securing the obligation and it was recorded in February of
1993.
The SCIN provided for monthly payments for the shorter of 11 years or the father’s death.
At some point after the note was signed, Costanza told his son Michael that Michael need
not make a payment every month and could instead pay him quarterly, which Michael did.
On March 8, 1993, Michael made the note payments for January, February, and March by
means of three back- dated checks. But Michael made no further payments on the SCIN
after that and his father died on May 12, 1993.
Costanza Sr. had been suffering from heart disease during the final 15 years of his life –
but died unexpectedly from a toxic reaction to bypass surgery performed the previous day.
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According to actuarial tables (See NumberCruncher for expectancies and tables showing
the probabilities of survival at various ages – Leimberg.com or 610 924 0515), at the
time he signed the SCIN, Costanza’s life expectancy was between 5 and 13.9 years.
Michael, the estate’s executor, filed a federal estate tax return declaring that the estate had
no estate tax liability. The estate tax return identified the SCIN as an estate asset, but
claimed that the note had no value to the estate due to the “cancel remaining debt-upon-
death” provision.
The IRS issued a deficiency notice that proposed an increase in Costanza’s gross estate
because (1) the SCIN was not a bona fide transaction, or, in the alternative, (2) the
transaction was a "bargain sale" that would increase the estate's adjusted taxable gifts.
The Tax Court agreed – with the IRS - and ruled that the sale was not a bona fide
transaction. It held that the SCIN provided no consideration for the restaurant and
properties. Consequently, their full value (minus the three payments deposited by
Michael) was a taxable gift from father to son.
Michael appealed the judgment of the tax court with the contention that the tax court erred
in holding that the sale was not a bona fide transaction.
The big advantage of a SCIN is that, assuming it is bona fide, a SCIN leaves "no interest
remaining in the decedent at his death," and therefore is "not includible in his gross estate."
But the IRS asserted that an estate tax must be paid on the value of a decedent's adjusted
taxable gifts and the Tax Court agreed with the Service that Costanza’s estate was liable
for that tax because the transfer of the properties to Michael was a gift rather than a bona
fide transaction.
ASCIN signed by family members is presumed to be a gift and not a bona fide transaction,
("Intrafamily transactions are subject to rigid scrutiny”). But this presumption may be
rebutted by an affirmative showing that there existed at the time of the transaction a real
expectation of repayment and intent to enforce the collection of the indebtedness.
The question is, what IS sufficient evidence of a bona fide transaction? Clearly, as far as
the IRS is concerned, "the giving of a note or other evidence of indebtedness which may be
legally enforceable is not in itself conclusive of the existence of a bona fide debt. To rebut
the presumption of a gift in this case, the taxpayer must clearly show that it was the
intention of the parties to create a debtor-creditor status.
Michael affirmatively testified that it was the Costanzas' intention for Michael to satisfy all
of the payments due pursuant to the SCIN. Costanza’s attorney also testified that the
Costanzas expected the note to be paid in full.
When asked if Costanza was “willing to simply gift these properties to Michael?” the
attorney replied, “no” because Costanza wanted payment over time so he could retire in
Italy.
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When the Tax Court questioned the parties' sincerity and expressed concerns about the
actual date the documents were signed, the date on which the three payments were made,
and the fact that Michael altered the dates of the checks, Michael satisfactorily (according
to this court) explained all three circumstances.
The IRS had argued that father and son entered into the SCIN agreement because they
presumed that the father would die prior to his son’s fully satisfying the note. The
Service’s logic is that “If they had thought Costanza Sr. would outlive the final payment
due under the SCIN, there would have been no reason to have signed the SCIN, as opposed
to an unconditional promissory note.
The Appeals Court retorted that “This contention, however, basically questions the validity
of any SCIN, an argument that the tax court has long since rejected. It also noted that,
“despite the father’s heart problems; there was no evidence that either Michael or his father
presumed that the father would die within a few years of signing the SCIN, let alone within
five months of the signing. Medical experts testified at trial that Costanza Sr. was
expected to live somewhere between 5 and 13.9 years from the time that he signed the
SCIN. His premature death due to complications from surgery was clearly not anticipated.
In addition, the fact that the SCIN was fully secured by a mortgage on the properties
further refutes any inference that the sale was not bona fide.
So the Appeals Court here reasoned that the estate “rebutted the presumption against the
enforceability of an intrafamily SCIN by affirmatively showing that there existed at the
time of the transaction a real expectation of repayment and intent to enforce the collection
of the indebtedness.”
The IRS had an alternative argument in case the gift tax argument failed; it claimed that the
SCIN – if not a gift – was a bargain sale (i.e. part gift – part sale). This court sent the case
back to the Tax Court to resolve this alternative argument.
The note and other documents were back-dated, the checks for the first three payments
were not written when due, and were back-dated, and then payments stopped completely.
The seller, who had serious heart problems, died shortly thereafter.
According to the Tax Court: “the haphazard and, at times, contradictory manner in which
Michael undertook to make payments to his father falls short of establishing that there was
a valid arm's-length sale of the commercial properties involved.”
In his Tax Court opinion, Judge Laro states that all transfers to family members are
“presumed” to be gifts, and suggests the parties must prove the buyer really intends to
make the installment payments.
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How? And where does the law say that? The only authority cited by the Tax Court is a
1950s case holding that a sale of property between spouses is presumed to be a gift. In any
case, the 6th Circuit agrees there is a presumption of gift, as indicated by the following:
But a SCIN signed by family members is presumed to be a gift and not a bona fide
transaction, Estate of Labombarde. ("Intrafamily transactions are subject to rigid
scrutiny . . . . However, this presumption may be rebutted by an affirmative
showing that there existed at the time of the transaction a real expectation of
repayment and intent to enforce the collection of the indebtedness.")
The 6th Circuit goes on to say
The petitioners have thus rebutted the presumption against the enforceability of an
intrafamily SCIN by affirmatively showing that there existed at the time of the
transaction a real expectation of repayment and intent to enforce the collection of
the indebtedness. As such, we conclude that the tax court clearly erred in finding
that the execution of the SCIN was not a bona fide transaction.
PLANNING:
● Do not ignore terms and conditions of sale.
● Family installment sales are viable.
● We must create quality control and mechanical follow-through checklists
and “action matrix” – making sure the parties dot the i’s and cross the t’s.
ARMSTRONG: Estate of Frank Armstrong Jr., et al. v. Commissioner; 119 T.C. No.
13; No. 1118-98 (29 Oct 2002) Estate of Frank Armstrong v. United States, No. 0-1305,
2002 WL 53914 (4th Cir. 2002); United States v. Frank Armstrong, Jr. Trust, 86 AFTR. 2d
2000-6674 (W.D. Va. 2000).
RESULTS: In the latest - (This is at least the seventh reported decision involving
this plan) litigation involving a case that cannot seem to get out of the courts the Tax
Court in Armstrong has held that Code Section 2035(c) requires the inclusion of
federal gift tax on all transfers made by the decedent within three years of death,
regardless of who pays the tax.. In reaching this most reasonable conclusion, the Tax
Court at least infers that the federal estate tax does not require a "transfer" of
property.
FACTS: Armstrong made a series of gifts to donees in 1991 and 1992 and then died
within three years of the gifts.
While he paid the gift tax on a stipulated value for the gifts, the donees entered into an
agreement. They would pay any additional gift tax that should arise if it was determined
the transfers were undervalued.
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The donees and the estate argued, but the Tax Court rejected, the following arguments, and
granted a motion for summary judgment:
● There was no "transfer" of the gift tax that could be taxed at death as a
transfer of property subject to the estate tax - in other words, IRC §2035(c)
is invalid.
The Tax Court used about three pages of opinion and citations to elaborate on the
background material digested above in two paragraphs. What apparently bothered the court
was the argument raised by the estate that, since there was no "transfer" of property, how
could there be a transfer tax? This is where the opinion gets scary - the Tax Court holds
that the estate tax does not require a transfer of property!
Consider the following quotes:
● As the Supreme Court has made clear, however, this does not mean the
estate tax may be imposed only on "transfers." Fernandez v. Wiener, 326
U.S. 340 (1945)
● The transfer of property at death is a "sufficient condition - but not a
necessary one - for a constitutional tax" (citing Bittker & Lokken, Federal
Taxation of Income, Estates, and Gifts.)
Did the Tax Court really mean to hold that transfers of property are not required to trigger
transfer taxes? The context of the citations was to make it clear the tax could be imposed
on lifetime transfers, i.e., the gift tax, and that Congress has at least some power (maybe)
to impose other forms of death taxes. In fact, the Court here goes on to say that the Code
imposes the estate tax on a single transfer - "the transfer of the taxable estate." In other
words, IRC §2035(c) was adopted to limit the ability to make a lifetime transfer that
depletes the estate at death. But some kind of transfer is still required, and the Court in this
case appears to acknowledge that.
Will this opinion open the door to the use of the so-called "estate depletion" theory of
transfer taxation, under which ANY action taken by the owner of property which reduces
the value of his or her estate will be treated as a "transfer" of property? The most obvious
example? Valuation discounts.
While recent court decisions do not seem to he taken that theory seriously, there is some
language in Tax Court opinions suggesting that some of the judges are thinking about it.
This case should be limited to its unique facts. The unfortunate language relating to the
need for a "transfer" should simply be disregarded.
What we've got (at least for now) IS a transfer tax. What should be taxed is the value of
that transfer.
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PLANNING:
● Carefully consider the implications of a provision requiring donees to pay
tax on a gift.
● In spite of the hysteria over gifts within three years of death, a study of the
actuarial tables will show that at almost any age, the chances of death
within three years are very small and may well be worth it – particularly
where includable life insurance is involved.
WELLS FARGO Wells Fargo Bank New Mexico, et al. v. United States; No. 01-
2212 (11 Feb 2003), Estate of Sanford v. Commissioner, 308 U.S. 39 (1939); Estate of
Davenport v. Commissioner, 184 F.3d 1176 (10th Cir. 1999). Commissioner v. Wemyss,
324 U.S. 303, 306 (1945). Tres. Reg. § 25.2511-2(b).
RESULT: The taxpayer in the Wells Fargo case tried to avoid the consequences of
the disallowance of the marital deduction by asserting no gift was effectively made
under state law, and, therefore, no gift tax can be assessed. But by creating an
irrevocable life interest on behalf of her spouse, the donor/grantor completely parted
with dominion over the transferred funds. Under federal law, that action -
relinquishment of dominion and control - made the event taxable.
The Tenth Circuit Court of Appeals reversed the US District Court (which had held
the event giving impetus to the tax was an incomplete transfer under New Mexico
law; thus, no gift took place, and the Estate owed no federal gift tax) and held that the
imposition of the gift tax is dependent on federal tax statutes, and not state law.
FACTS: Mary Nielsen set up a trust designed to qualify as a lifetime QTIP trust in
order to obtain the gift tax marital deduction. It was set up as an irrevocable inter vivos
trust, and Mrs. Nielsen relinquished any and all rights over the property transferred to the
trust.
Unfortunately for Mrs. Nielsen, or actually her estate, the trust failed to qualify for the gift
tax marital deduction for one very simple reason: QTIP treatment was never elected.
Under the general rule for gift and estate taxes, transfers to spouses are entitled to a
marital deduction. But until the passage of the Qualified Terminable Interest Property
(QTIP) section 2056(b)(7) for estate tax and section 2523(f) for gift tax, the marital
deduction was not allowed for a transfer in the form of a terminable interest.
After the passage of Code Sections 2056(b)(7) and 2523(f), transfers of terminable interest
property qualify for the marital deduction if
(1) The receiving spouse has a lifetime interest in the entire income,
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(2) No part of the principal can be paid to any other person during the lifetime
of the spouse, and
(3) The election under the respective section is made on a timely filed tax
return.
The effect of the QTIP election is that the receiving spouse will be treated as the absolute
owner of the property for future application of the gift or estate tax.
In Mrs. Nielsen’s case, there was no dispute that all the elements of a QTIP trust were
there - except that the election was never made.
Note: More recent versions of the Gift Tax Return, Form 709, assume the election is made
by merely claiming marital deduction for the specific gift. Earlier versions required a more
affirmative action to elect QTIP treatment.
Mrs. Nielsen’s estate argued in District Court that, under New Mexico law, no gift was
made and therefore no gift tax could be assessed. It based this argument on the fact that
Mrs. Nielsen clearly indicated in the trust document that the trust was designed to qualify
for QTIP treatment, and since it did not, the gift was invalid. The District Court agreed
with this argument and granted the estate summary judgment.
The Internal Revenue Service appealed to the Tenth Circuit. That Court has reversed the
District Court, and remanded the case with instructions to enter judgment for the Service.
The Tenth Circuit ruled that donative intent is immaterial for purposes of determining the
application of the gift tax, and that federal gift tax law controls, rather than state law.
Federal gift tax law taxes completed transfers. The Court cited Treasury Regulations under
Code Section 2511, as well as Estate of Sanford v. Commissioner, 308 U.S. 39 (1939). In
that case the Supreme Court stated that a completed transfer is determined by whether
there is a “passage of dominion and control over the economic benefits of property”.
The notion is buttressed by Treasury Regulation Sec. 25.2511-1(g)(1) which states:
Donative intent on the part of the transferor is not an essential element in the
application of the gift tax to the transfer. The application of the tax is based on the
objective facts of the transfer and the circumstances under which it is made, rather
than on the subjective motives of the donor.
See also Tres. Reg. § 25.2511-2(b) (a gift is complete for federal tax purposes when "the
donor has so parted with dominion and control as to leave in him no power to change its
disposition.").
Here, Mrs. Nielsen’s trust document stated “Grantor intends to, and does hereby,
relinquish absolutely and forever all possession or enjoyment of, or right to the trust
property, or the income therefrom …and any interest of any nature …in the trust property”.
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The Court’s opinion noted that the language of the trust document made clear the finality
of the transfer of funds to the trust. That was sufficient to cause the transfer to be subject
to the gift tax, notwithstanding the fact that the donor’s intention, creating of a QTIP trust,
was not carried out.
The Court did state that all the elements to create a QTIP trust was there, and had the
election required by section 2325(f)(1) been made, no gift tax would have been due on the
transfer. But, as the Court stated, “unfortunately for Ms. Nielsen, for the want of an
election, an exemption was lost”.
PLANNING:
● Details, Details, Details
● Establish a quality control checklist for all elections and other time sensitive
actions. Consider an “Action Matrix”
QPRTS
IRS QPRT FORM: Revenue Procedure 2003-42.
RESULT: In Revenue Procedure 2003-42, published in the Internal Revenue
Bulletin 2003-23 dated June 9, 2003, the Internal Revenue Service issued an
annotated sample declaration of trust and alternative provisions designed to meet the
requirements of §2702(a)(3)(A) of the Internal Revenue Code and §25.2702-5(c) of the
gift tax regulations.
IRS will generally not issue a letter ruling on whether a trust with one term holder qualifies
as a QPRT. It will, however, rule on the effect of substantive trust provisions other than
those in the Rev. Proc.
As is the case with the IRS’s charitable remainder trusts forms, the sample QPR form is
not a panacea or by any means a perfect planning document.
Consider the following potential deficiencies:
● Sample form does not provide the almost universally included provision
that, if the grantor dies during the trust term, the trust assets will revert to
the grantor’s estate. This is important because the reversion is an additional
retained interest which will reduce the gift on creation of a QPRT. (Note: In
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the case of GRATs, a retained reversion is ignored for gift tax valuation
purposes.)
● Sample form does not provide for the residence to pass on termination to a
second grantor trust. This is important to assure gain on sale of residence
will be excluded under Section 121. Also, this protects rent paid by grantor
to trust from being treated as taxable income to beneficiaries – since it is
treated as paid to self if the recipient is a grantor trust. Compare this with
taxation if house rented directly from QPRT’s remainder beneficiaries.
● Provision prohibits sale to grantor. A sale of the house to the grantor by the
QPRT – which would cause the home to be included in grantor’s estate and
thus yield a step-up in basis – is desirable – and should be allowable.
● In event QPRT no longer qualifies:
1. Assets must be held as a separate share in a GRAT, or
2. Trust may direct that the assets may be returned to the
transferor, or
3. Trust may give to a trustee who is independent of the
transferor the discretion either to elect to return the assets to
the transferor or to hold the assets in a GRAT.
More flexibility should be possible. For example,
● Allow grantor as trustee to hold power.
● No reason for trustee to be independent.
PLANNING:
● Use IRS form as starting point for custom drafted QPRTs
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CHARITABLE ISSUES
MARTIN: Raymond Martin v. Ohio State University Foundation, et. al. , 139
Ohio App. 3rd 89; 742 N.E. 2nd 1198; 2000 Ohio App. Lexis.
RESULT: A Court of Appeals found that an attorney and insurance agent were
guilty of both fraud and negligent misrepresentation in an estate plan which
suggested a client set up a CRUT (Charitable Remainder UniTrust) and a Wealth
Replacement Insurance Trust.
FACTS: Back in the ‘50s, Ray Martin purchased about 4 acres of farmland in rural
Ohio. In the mid ‘80s, due to rezoning, the land increased dramatically in value - at least
according to the property taxes they were paying on it. Martin, who wasn't earning a great
deal, wanted to sell the property but couldn't find a buyer.
Late in 1989, an insurance agent, Clark, who "performed financial and estate planning"
learned of their plight. Martin, now in his middle ‘60s, confirmed that he wanted to sell the
property and retire to Florida. No problem, said Clark. Just transfer the land into a CRUT.
Clark told Martin that the CRUT would generate an income stream they could use to both
purchase a life insurance policy to replace the gift they were making to charity and to
finance the new retirement property in Florida they wanted to buy.
Clark introduced Martin to Wolfe who called himself a lawyer and financial planner.
Wolfe used a popular and well-known financial planning software package to develop
recommendations.
Clark and Wolfe decided that the Ohio State University (OSU) Foundation would be the
CRUT's trustee. They took Martin to meet with Fellows, the Director of Trusts and Estates
for OSU.
Early in 1990, Clark and Wolfe gave Martin a "Cash Flow Analysis" reflecting that
monthly payments from the CRUT would equal or exceed the outflows from the costs of
the Florida property mortgage and life insurance premiums.
Clark then directed yet another attorney, Hertenstein, an "estate attorney" to draft a CRUT
document. Hertenstein never met with Martin, never discussed his situation on the phone,
and never corresponded with Martin by mail or fax.
Fellows, from OSU, sent Wolfe a memo about the CRUT stating that "no payments will be
made from the trust until after the sale." But neither Fellows nor Wolfe ever sent a copy of
the memo to Martin.
Clark and Wolfe prepared a memo for Martin detailing their financial plan proposal stating
that payments from the CRUT would begin the first year. But Fellows called Clark and
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reminded him that there would be no income from the property until it was sold by the
CRUT. Fellows never mentioned this to Martin.
Clark redrafted the financial plan document and deleted the line that stated that payments
would not begin until the property in the CRUT was sold.
Martin was not given the CRUT until the day he signed it in August of 1990. Nor did Clark
or Wolfe, who went with him to the closing, explain the terms of the CRUT. Martin,
believing the CRUT would start to make payments to him immediately, made payments on
the Florida property and paid the premiums on the $1,000,000 of life insurance.
Of course, since the property they placed into the trust had not been sold, Martin didn't get
anything from the CRUT. When they called Clark to complain, he told them, for the first
time, that payments would not start until the trust sold the property. Eventually, Martin
found he was unable to pay the premiums and the policy lapsed. Martin never received a
payment from the trust - until 1993. The payments he received were not the 8 percent
originally projected or the 7 percent Fellows suggested were more realistic but in fact
"never more than 5 percent per year up to the time of trial."
Martin sued the OSU Foundation, its treasurer, Clark, Clark's company, and the insurer.
(The suit with OSU and its treasurer was later settled - for almost $700,000!) The suit was
for fraud, negligent misrepresentation, breach of contract, and breach of fiduciary duty.
Fraud is essentially an act or omission with ALL of the following 6 elements:
(1) REPRESENTATION OR OMISSION: There must be a representation or,
where there is a duty to disclose, a concealment of a fact.
Courts will not find fraud merely because someone makes promises or
representations about future actions or conduct. Most courts will treat
representations about future performance as "predictions" rather than
fraudulent misrepresentations. But if a person makes a promise to take
action in the future - or promises that something will occur or not occur -
and knows at the time he makes the statement that he has no intention or
ability to keep that promise, the courts will find in the lie and mental
attitude and present intent the requisite misrepresentation of an existing fact.
Martin and his company were found guilty of both representation and
concealment of facts. In none of the many impressive documents they
presented to the client did they mention a very important fact: " no sale - no
annuity". To the contrary, they deliberately omitted statements that would
have alerted Ray and Peg to the problem.
(2) MATERIAL: The representation made - or the fact concealed - must be
material to the transaction at hand.
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Clark and Wolfe were clearly aware that Ray and Peg Martin needed the
annuity income to finance both the Florida property and the $40,000 a year
insurance premium. (They knew or should have known Ray was earning
only $24,000 a year in 1990).
(3) KNOWLEDGE: The statement (or omission) must be made falsely, with
knowledge of its falsity, or with such utter disregard or recklessness as to
whether it is true or false that knowledge may be inferred. Clark and
Wolfe's many projections and printouts showing CRUT payouts matching
or exceeding Ray's expenses were neither a "misunderstanding" nor a mere
prediction as to a future event. Nor was it a "non-actionable expression of
opinion. Every calculation, analysis, and plan they gave Ray - including the
crucial starting date of the annuity payouts - was based on his very specific
circumstances.
(4) INTENT: The statement (or omission) must be made with intent to mislead
another to rely on it.
Clark and Wolfe gave Ray only two options, the CRUT/Insurance Plan and
the "sell the property yourself" plan. And they made it clear that the later
was "bad". (Of course, the later plan didn't pay them insurance commissions
either). By doing so, they induced him to go in the direction they wanted
him to head - the one in which they would earn commissions.
(5) RELIANCE: The person injured by the statement or omission must
justifiably rely on it.
Ray and Peg never read the CRUT before they signed it. Does that negate
justifiable reliance? Did their failure to ask probative questions of Clark and
Wolfe regarding the payment date block them from relief? How could they
claim to be mislead when reading the contract would have revealed the
issue? Wasn't there an abandonment of care in informing themselves?
The Court held that all of these things yielded, in this case, to their right
(considering their age, (in-ex) experience in financial matters, respective
knowledge, and means of knowledge) to rely upon the integrity and
knowledge and representations of two "professionals."
(6) INJURY AND PROXIMATE CAUSE: There must be an injury and it must
be proximately caused by the reliance.
The amount necessary to make Ray (Peg had died of a heart attack) "whole"
based on the representations of Clark and Wolfe was almost $1,000,000, the
difference between what Ray actually received from the CRUT and the
amount Clark and Wolfe led him to believe he would receive - after taking
into account the almost $700,000 settlement with ) OSU.
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Negligent Misrepresentation requires:
(1) Pecuniary interest in the transaction,
(2) Supplying false information for the guidance of another in a business or
professional transaction, (3) Pecuniary loss caused by justifiable reliance
on the false information,
(4) Failure to exercise reasonable care or competence in obtaining or
communicating the information.
So the mere omission of a fact is not, per se, negligent misrepresentation. There must be an
affirmative false statement to be guilty of negligent misrepresentation. But planners must
be aware that "believing it is true isn't enough" to keep you safe.
Even though you may honestly believe what you say, YOU MAY BE NEGLIGENT IF:
(1) YOU HAVE FAILED TO TAKE REASONABLE CARE IN
ASCERTAINING THE FACTS, or
(2) YOU WERE NOT CAREFUL IN THE MANNER YOU EXPRESSED
YOUR STATEMENTS, or
(3) IF YOU DON'T USE THE SKILLS AND COMPETENCE REQUIRED
BY YOUR PROFESSION.
POSTSCRIPT:
The appellate decision arose because the trial court granted defendants' motions for
summary judgment. The Court of Appeals held that the plaintiff presented a sufficient case
to take to the jury. The case was remanded to the trial court.
The Ohio State University Foundation (OSUF) agreed to buy from Mr. Martin his interest
under the CRT and that the agreed value of Mr. Martin's interest was what OSUF paid. As
a result, OSUF received all of the property of the CRT immediately.
There was testimony presented that Mr. Martin indicated that the land that would be the
subject of the CRT would sell easily. Mr. Martin had reason to know that this was not true,
but did not share this information with Mr. Clark or his other advisers.
The matter ultimately did go to a jury. The jury returned a verdict of about $180,000. The
plaintiff sought in excess of $1,000,000."
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Clients can and do "hold back" or "forget" both important facts and opinions. Martin
teaches us that we are not immune to suit merely because, as is often the case, the client is
"negligent" in some respect (although the client's negligence may diminish or eliminate
damages).
Certainly we are not totally at fault when we are mislead by a client with respect to a
material fact and the problem is caused or increased by his or her action. But Owen Fiore
wisely reminds us that "IT IS THE ADVISOR'S DUTY TO ASK THE RIGHT
QUESTIONS."
PLANNING:
(1) Ask the tough questions, such as "How will you pay for your Florida
property and the life insurance this report tells you would replace the real
estate your son will not get - if the property you put into the CRUT this
report tells you to create - is nonproductive?
(2) Be sure you know who your client is – and be sure your client knows you.
The attorney in this case who drafted the CRUT documents NEVER MET
THE CLIENT! NEVER SPOKE TO THE CLIENT. NEVER
COMMUNICATED WITH THE CLIENT. So who did the attorney
represent? What were his responsibilities to the person for whom the
document was drafted? How could he relate the law to the facts (which he
obviously couldn't and didn't) if he never met the client or interacted in any
way?
(3) Be both realistic and courageous enough to be conservative about your
projections. Always give clients a range of possibilities showing (1) a very
conservative, (2) moderate, and (3) aggressive long-term after-tax and other
"slippage" rate of growth/income.
(4) Tell clients that the payout projected from the CRUT in software printouts
is not guaranteed. Don’t let client assume what client wants to assume.
Discuss with client things obvious to your but which would not be so
obvious to the typical client. Say things to the client he/she may not want to
hear - but that are critically important to the success of the client's overall
objectives and to the client's ability to make an informed decision.
(5) Inform other professionals involved – AND client – about problems and
issues – ASAP. Communicate earlier, more often, and more effectively -
particularly about the costs, downsides, and potential problems with the
course of action suggested to the client. (And document and file each and
every client interaction).
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(6) Share documents with clients sufficiently ahead of time – and then explain
them. Summarize and put that explanation in writing so our clients can't
forget the key things we've told them. Do not allow clients to sign any
documents without explanation. Take the time to make sure clients have a
fair chance to understand what it is they are doing.
(7) Make very clear in your client presentations what is promise - and what is
prediction - and label them (or insist they be labeled) accordingly. Separate
general concepts and hypotheticals from specific "this is YOUR life"
projections.
(8) When you make a mistake - and you WILL - admit it and fix it - fast!
(9) Present clients with the pros - and cons - of the viable alternatives to our
suggestions. If we give them only one road to travel down, they can't make
their own informed objective decision and must place total reliance on us.
We thereby lose a very important input in the planning process - what the
client brings to the table.
INCOME TAX
APNT: PLR 200148028
FACTS: PLR 200148028 describes an APNT. In Private Letter Ruling 200148028,
the IRS determined that, based on the grantor's limited powers over his irrevocable trust,
he will not be treated as the owner of the trust for income tax purposes. However, the IRS
also found that there is no completed gift for gift tax purposes.
Under the facts of this ruling, there were adverse parties – without whose consent –
distributions could not be made and provisions in the trust ensure that the Grantor will not
be able to act independently of an adverse party. The restrictions on the powers of the
Trustee preclude the Trustee from independently controlling distributions or making loans
without the consent of an adverse party.
In this PLR, the Grantor proposes to irrevocably transfer property to the Trust. Grantor will
retain a limited power to appoint Trust property (and accumulated income) to other family
members. By reason of Grantor's limited power of appointment, Grantor will have the
power to change the beneficiaries of Trust. Therefore, for purposes of the gift tax, Grantor
will continue to possess dominion and control over the property transferred to Trust and
the irrevocable transfer to Trust will not be a completed gift.
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How do you create an APNT?
For estate and gift tax purposes, to keep the trust in the grantor’s estate, and to avoid
making a completed gift, the grantor can retain a special power of appointment over the
property in the trust.
For income tax purposes, to keep the trust from being a grantor trust, the trust should
provide that distributions cannot be made without the consent of an adverse party.
PLANNING:
● If estate taxes are repealed, if the estate is below the applicable credit
thresholds, and if saving income taxes can be accomplished, the APNT
should be considered.
● Be sure to retain the appropriate limited powers over the trust, be sure there
are adverse parties, and ensure the grantor can’t act independently of those
parties.
EMPLOYEE BENEFIT ISSUES
412(i): “Fully Insured 412(i) Pension Plans Offer Simplicity
and Low Risk”, Leimberg and McFadden, Estate Planning, April
2003, Vol. 30, No. 4, Pg. 155; Choate, “Life Insurance Inside the
Retirement Plan”, Trusts and Estates, Vol. 142, No. 5, May 2003,
Pg. 50. Keeping Current provided by the Society of Financial
Services Professionals (Vol 33, No. 3, June 2003) (800 392 6900)
FACTS: Not content with the many advantages of perfectly
legitimate 412(i) programs provided by economically sound and
highly ethical insurance carriers, some promoters try to make a
good thing “better” and end up with over the edge abusive 412(i)
plans that will cause them and their clients much grief.
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Consider a typical 412(i) plan funded 100% with cash value life
insurance. Assume the plan has a 55 year old participant and the
normal retirement age of the plan is 65. His defined monthly
pension will be $10,000. To finance a $10,000 a month guaranteed
benefit at the carrier’s current annuity rates will require about $1.7
million at the participant’s age 65. Rather than fund this plan
partially with life insurance and partially with an annuity, the
promoter interprets Code Section 412(i) to read that it is permissible
to use an individual cash value life insurance contract to fund the
entire benefit.
Proof of the validity of this approach is offered in the form of an
opinion letter from - well of course - the always available “large and
prestigious law firm - that assures the reader a "more than likely"
positive result and that it is more than likely the plan meets all
necessary Code requirements.” Of course, once we clear that bar,
the rest of the fable is easy. Since (according to the promoter’s
opinion letter) the plan can be 100 percent funded through an
individual life insurance contract, it is only a matter of mathematics.
Figure how much face amount must be purchased to obtain the
guaranteed cash value needed to produce $10,000 a month at age 65
- and we already know that we need roughly $1,7000,000 - so
working backwards - we need to purchase a policy of about
$8,500,000!
Well isn’t there an “incidental limit” to contend with? Can we really
purchase almost $9,000,000 of insurance - and not push the
“insurance must be incidental” envelope? Is it still really a pension
plan with that much insurance? Not to worry, says the promoter.
We’re well within the limit since the participant’s family will
actually be paid only $1 million (within the "incidental limit" in the
plan document of 100 times the monthly pension). What happens to
the rest of the money - you wonder? Oh that? Well, we just keep
any "excess" in the plan. We’ll use if for funding benefits for other
participants. That’s nice - except we forgot to mention that there
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are no other plan participants. And we certainly don’t want the
excess death proceeds to revert to the company. That’s because an
excise tax would be imposed and when eventually paid out to the
sole shareholder’s family, it will be taxed again. No problem, say
the promoters of this type of arrangement. It will never happen that
way. The policy - and its values - will be long gone by then. We’ll
set this thing up to last for just five or six years. At that point, the
plan transfers the insurance contract to the participant as a taxable
distribution or sells it to him/her or to a trust for its current (nothing
up this sleeve) cash value.
Now let’s suppose we put in about $3,000,000 by that point - and
the policy has a bail-out cash value of only $600,000. So you pay
tax on - or buy it for - pennies on the dollar. And all the while, your
corporation has been receiving tax deductions! But, you say, why
would I want a policy that is such a poor investment that the
pension plan no longer cares to own it? Simple. This is not a
regular policy. It’s a magic bean stalk policy. Don’t worry it is so
tiny when you get it or that it shrunk so much while planted inside
the pension. Just wait a few years and the contract's cash value will
grow back to - we guarantee - almost $3,000,000 - and you don’t
even have to water this magic bean with more premiums!
And wait, there’s more! When you hit age 65, you can take loans -
each year - income tax-free. According to my calculations, says the
promoter, you can take almost a quarter of a million dollars a year -
every year - for the next 15 years! So if you are willing to pay - just
the tax on a little over $600,000 - this plan will generate almost
$4,000,000 of tax-- free income. What could be wrong with THAT!
Harry HonestAgent is showing his client a more conventional
(albeit less appealing) 412(i) plan. Perhaps, instead of funding the
plan entirely with life insurance, he might hold down the death
benefit to $1 million. That might require a premium of a little more
than $70,000. And it would result in a guaranteed cash value of
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slightly less than $600,000. So where does the rest of the money
come from? An annuity. Now the total plan annual deductible
outlay is about $160,000 - rather than the almost $650,000 annual
contribution required in the abusive plan. Well, of course it’s no
where near as attractive as the abusive plan. That’s because it’s legit
- its real - and few real things have the appeal power of magic bean
stalks.
PLANNING:
● 412(i) Plans are legitimate and will work well if used
in the proper circumstances.
● Don’t be aggressive in this area – Don’t try to provide
excessive amounts of insurance or plan in advance to
withdraw life insurance and artificially undervalue it.
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