Recent developments in estate planning.

• Author: Ransome, Justin P.
• Position: Part 1

This is the first in a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and trust income tax between June 2013 and May 2014. Part 1 discusses gift, estate, and GST tax developments. Part 2, which covers trust developments, the taxation of trusts under the new 3.8% net investment income tax, President Barack Obama's estate and gift tax proposals, and inflation adjustments for 2014, will be published in the October issue.

Gift Tax

Valuation

Under Sec. 2035(b), the amount of the gross estate includes any gift tax paid by the decedent within three years before the decedent's death. In Steinberg, (1) the Tax Court denied the IRS's motion for summary judgment and concluded that, for gift tax purposes, a donor could reduce the value of gifted property by the value of the donee's assumption of the donor's potential Sec. 2035(b) estate tax liability.

On April 17, 2007, the 89-year-old donor entered into a binding gift agreement with the donees, her four children. In the agreement, the donees assumed liability for any gift tax imposed on the donor's gift--a "net gift" arrangement in which the value of the gift is reduced by the value of the gift tax liability the donees assumed. The donees also agreed to assume any liability for the Sec. 2035(b) estate tax due if the donor died within three years of the date of the gift--a "net, net gift" arrangement.

On Oct. 15, 2008, the donor filed a timely gift tax return based on an appraisal that valued the net gift at approximately $71.6 million and the actuarial value of the donees' assumption of the potential Sec. 2035(b) estate tax liability at approximately $5.8 million. The IRS denied the donor's discount for the donees' assumption of the potential tax liability and issued a notice of deficiency. After the donor filed a Tax Court petition, the IRS responded with a motion for summary judgment asserting that the donees' assumption of the potential tax did not constitute consideration for purposes of determining the value of a net gift.

Under Sec. 2035(b), if a decedent dies within three years of paying any gift tax, the gift tax is included in the decedent's estate. A "net gift" is a gift in which the donee assumes responsibility for payment of the gift tax imposed on the transfer. The donor calculates her gift tax liability by reducing the value of the gift by the gift tax liability the donee assumed, because the assumption of the gift tax liability is treated as consideration, converting a net gift into part gift and part sale.

The IRS argued that the donees' assumption of the potential Sec. 2035(b) taxes was worthless and provided no monetary benefit to the donor. As such, the donees' assumption of potential tax failed as consideration under the "estate depletion" theory, which stands for the proposition that the amount of consideration in a gift transaction is measured by the benefit to the donor in money or money's worth.

The donor's argument rested on the Fifth Circuit's decision in Succession of McCord. (2) In McCord, the taxpayers gifted limited partnership (LP) interests to their sons who agreed to be liable for any transfer taxes on the gifts, including gift tax, estate tax, or GST tax. The taxpayers reduced the value of the gift to their children by the actuarially determined value of the sons' contingent obligations to pay any estate tax. The Tax Court agreed with the IRS that the taxpayers could not reduce the value of their gift by the, value of the sons' obligations to pay any potential estate taxes arising from the transaction because no recognized method exists for approximating the estate tax liability with a sufficient degree of certainty. In addition, the Tax Court suggested that the taxpayers' reduction of the value of their gift failed under the estate-depletion theory because, if the donee paid any estate tax imposed by Sec. 2035, the payment would benefit the donor's estate (and the beneficiaries) rather than the deceased donor.

The Fifth Circuit reversed the Tax Court, holding that nothing was so speculative about the sons' assumption of the potential Sec. 2035(b) estate tax liability that would prohibit valuing that liability. Generally, the value of a gift is the price at which the property would change hands between a willing buyer and willing seller. Although it was not certain that the donor would die within three years of making the gift, a willing buyer would insist on the willing seller's recognition of the three-year exposure to Sec. 2035 estate taxes be taken into account in valuing the gift. As such, the Fifth Circuit determined that the assumption of the potential Sec. 2035 estate tax liability was not so speculative that it was worthless.

In Steinberg, the Tax Court agreed with the Fifth Circuit's decision in McCord and concluded that the donees' assumption of the potential Sec. 2035(b) estate tax liability may be treated as consideration reducible to a monetary value that reduces the value of the donor's gift. The Tax Court also reexamined its previous analysis of the issue in McCord.

First, the Tax Court looked at Robinette v. Helvering, (3) in which the Supreme Court held that the value of a contingent reversionary remainder interest of property in trust could not reduce the value of the gift in trust because there was no recognized method to value the interest. Robinette involved a complex contingency in which the reversion of property to a mother depended on the mother's surviving her unmarried daughter and the unmarried daughter's dying without issue before the age of 21. The Supreme Court distinguished this complex remainder interest from a simple contingent remainder based only on survivorship, noting that a simple contingent remainder could be valued actuarially. The Tax Court found that the contingency at issue was a simple contingency based only on survivorship.

The Tax Court also concluded it is possible to determine the amount of a potential Sec. 2035(b) estate tax liability using the rates and exemptions on the date of the gift even though estate tax rates and exemption amounts are subject to change. It pointed out that with respect to the capital gains tax, many courts have held that the fair market value (FMV) of gifts or bequests of stock must be reduced by the potential tax liability on the built-in capital gains on the valuation date, even though the tax will not be paid until an unknown time in the future and the capital gains rates have changed many times.

The Tax Court further noted that it incorrectly analyzed the estate-depletion theory in McCord because it distinguished between a benefit accruing to the donor versus a benefit accruing to the donor's estate. In Steinberg, the court found that for purposes of the estate-depletion theory, the donor and the donor's estate are not separable. Under the estate-depletion theory, whether a donor receives consideration is measured by the extent to which the donor's estate is replenished by the consideration. Because a donee's assumption of a Sec. 2035(b) estate tax liability may provide a benefit to the donor's estate, the court determined that the donee's assumption may satisfy the estate-depletion theory

The Tax Court next addressed the IRS's argument that the assumption of the Sec. 2035(b) liability should not reduce the value of the donor's gift but, instead, should be treated as a gift from the donees to the donor. The IRS argued that any transfers between family members are necessarily treated as gifts unless it is shown that the transfers were made in the ordinary course of business. The court rejected this argument and pointed out that a transfer between family members is not a gift to the extent it is made for consideration in money or money's worth even if the transfer is not in the ordinary course of business. In conclusion, the court denied the IRS's motion for summary judgment.

The opinion was a fully reviewed opinion. Seven of the Tax Court judges concurred with the court's opinion, and six of the judges concurred in the result only. One judge dissented. This case presents an opportunity for donors to reduce the value of their gifts using the net, net gift approach. In this particular case, the amount of the estate tax contingency reduced the value of the gift by $5.8 million.

EXECUTIVE SUMMARY

* The Tax Court, abandoning its prior position, held that, for gift tax purposes, a donor could reduce the value of gifted property by the value of the donee's assumption of the donor's potential Sec. 2035(b) estate tax liability. This case illustrates the "net, net gift" approach.

* Trust beneficiaries were not allowed to disregard the estate tax special-use valuation of land they inherited in trust when later determining the basis of a conservation easement on the land in calculating gain on the sale of the easement.

* The IRS issued a private letter ruling addressing the tax treatment of a generation-skipping trust created in 2010, when the estate tax was not in effect.

* In Estate of Richmond, the Tax Court has returned to the present-value concept to determine the discount for built-in capital gains tax when valuing an interest in an entity for estate tax purposes.

Estate Tax

Basis of Inherited Property

Under Sec. 1014(a)(1), the tax basis of inherited property is usually its FMV at the date of death. However, when a Sec. 2032A special-use valuation is elected, Sec. 1014(a)(3) provides that the property's tax basis is its special-use value instead of its FMV. The estate tax benefit of this election is that the value of the property included in the gross estate is determined by valuing it in its actual use at the time of death, rather than in its highest and best use. In Van Alen, (4) the beneficiaries, who received property from their father's estate for which a Sec. 2032A election had been made, ignored the special-use valuation when they sold the property and instead reported their gain using the...