ESTATE TAX GROSS-UP OCCURS FOR GIFT TAXES PAID UNDER SECTION 2519 WITHIN 3 YEARS OF DEATH

[NOTE: This is a technical issue that is probably of interest to only a small subset of the readers of this blog. For more information on Section 2519, you can review my article from earlier this year entitled Tax Results of Settling Trust Litigation involving QTIP Trusts published in the January 2009 edition of Estate Planning, a WG&L publication. I will also be speaking on the same subject in January 2010 at the Heckerling Institute on Estate Planning.]

Section 2519 of the Internal Revenue Code imposes a gift tax when all or a portion of a QTIP trust (a specific type of marital deduction trust established by one spouse for another to reduce estate and/or gift taxes) is distributed during the lifetime of the beneficiary spouse to beneficiaries other than the spouse. The gift taxes are payable by the spouse – however, the spouse can “recover” the taxes from the beneficiaries who receive the assets of the trust that triggered the tax.

Section 2035(b) requires that any gift taxes paid by a decedent within 3 years of death be added to the gross estate of the decedent for purposes of computing estate taxes. In a recent Tax Court case, the issue arose whether gift taxes paid under Section 2519 are subject to this 3 year gross-up rule for the gift taxes paid within 3 years of the spousal beneficiary’s death.

The estate made a strong argument that the gross-up rule should not apply, at least when the spouse exercised her rights to recover the gift taxes arising under Section 2519 from the other trust beneficiaries. This is because the Section 2035(b) gross-up rule applies only to gift taxes of the spouse, and in this circumstance the substance of the transaction is that the other beneficiaries of the QTIP trust paid the gift tax.

The Tax Court was not persuaded by the estate’s argument, and held the gross-up ruled applied. The Court noted that under the Code, the gift tax is imposed on the spouse. The “right of recovery” of the spouse is just that – and is not technically a shift in who is primarily liable for the tax.

The Court noted that to rule otherwise would violate the policy of Section 2035(b) which is to prevent death bed transfers that would incur gift tax, and thus remove the gift taxes themselves from being subject to estate tax on the subsequent death of the grantor. The Court believed that if the gift tax incurred under Section 2519 was not covered by the gross-up rule, spousal beneficiaries of QTIP trusts would have the incentive to terminate the trusts prior to death (where death is foreseeable) so as to avoid estate taxes on the amount of gift taxes incurred.

Estate of Anne W. Morgens, et vir. v. Commissioner, 133 T.C. No. 17 (December 2009)

“GIFT OVER” FORMULA CLAUSE RESPECTED BY TAX COURT

Taxpayers often desire to make gifts of difficult to value property by using their available unified credit  to cover the value of the gift and thus avoid current gift tax. The problem they face is that if the IRS is successful in proving a higher value for the property than the taxpayer, this could put the taxpayer over the unified credit amount and thus incur current gift taxes.

To address this problem, taxpayers use “formula clauses” to limit the amount of the gift to the desired amount. The IRS typically contests these clauses, claiming they are against public policy since they reduce or eliminate the IRS’ incentive to auditing.

One type of clause used is known as a “gift over” clause. In this type of clause, the taxpayer gifts away the property, but provides that to the extent that the value of the gift exceeds a certain dollar amount, the remaining value goes to another recipient (typically one or more charities). Thus, any unexpected increases in value on IRS examination act to increase the amount going to charity – no additional gift tax results due to the charitable gift tax deduction.

In a taxpayer victory, the Tax Court has upheld the application of such a clause after the IRS successfully argued for a higher value for gifts made by a taxpayer than the value reported on the gift tax return. Facts and factors that assisted the court in reaching its decision included:

A. The Court noted this clause was not in the nature of a prohibited Proctor “savings” clause that returns property to the grantor to the extent of any finally determined increases in value. Instead, under this type of clause, no matter what the final valuation of the gifted property the taxpayer gifted away the same property, with the only uncertainty being who receives it (based on values finally determined).

B. The Court feels less comfortable in relying on public policy arguments than it has in the past. The Court cited Commissioner v. Tellier,  383 U.S. 687, 694 [17 AFTR 2d 633] (1966), where the Supreme Court warned against invoking public-policy exceptions to the Code too freely. The Court also noted the contrary public policy of encouraging gifts to charities, which gifts are supported by these types of clauses.

C. The Court noted that there were a number of facts that demonstrated fiduciary and legal obligations of various parties to respect the rights of the charitable beneficiaries, and thus limits the ability of the taxpayers to exploit the presence of the charities for tax planning purposes via low-ball valuations. Indeed, the charities were active in this case in negotiating the transfers and enforcing their rights. The case also presents useful guidance in regard to structuring the charity’s gifts in a manner that enhances these types of factors (e.g., by making the charities a full member in the LLC in which they received gifts instead of just holders of restricted transferee interests).

D. The Court also acknowledged that the Code and Regulations allow the use of formulas in various circumstances, so that formula clauses should not be preemptively declared to be against public policy in all circumstances. This is an argument often made by taxpayers and it is helpful that this argument was acknowledged, at least in part, by the Tax Court.

An interesting side issue in the case was whether the charitable deduction for the gift should be allowed in the original year of gift, even though the amount of the charitable gift was effectively increased by the IRS’ later higher valuation in a later year. The Court found that the charitable deduction occurred in the year of the original gift.

Petter, et al. v. Commissioner, TC Memo 2009-280

APPLICABLE FEDERAL RATES – JANUARY 2010

CONGRESS FAILS TO ACT ON ESTATE TAXES

Congress has had nine years to clean up the unusual situation of there being no federal estate taxes in 2010, and then a reversion to 2001 rates and exemptions in 2011 and thereafter. Last minute efforts this month to avoid the repeal of the tax in 2010 have failed, and for the first time in many years, there will be no estate taxes (but only for 2010).

It is likely that Congress will revisit the issue in 2010. What shape any resulting action takes is difficult to predict. Republicans may have the early edge to bargain down rates and increase the unified credit, but as the clock ticks towards 2011 with its built-in rate increases and substantial unified credit decrease, bargaining power may shift to the Democrats. Whether Congress will touch the political hot potato of a retroactive re-imposition of the tax is an interesting question.

Unfortunately, the repeal of the estate tax also brings in the abomination of carry-over basis. Presently, if someone dies, the adjusted basis in their property is adjusted to current value. In a carry-over basis regime, such adjustment does not occur, and the heirs receive the same basis the decedent had for calculating gain or loss on a future disposition and for other purposes. How the heirs are supposed to have basis information if the decedent is deceased and was not a good record keeper is anyone’s guess, and one of the reasons why carry-over basis is terrible tax policy from an administrative and compliance perspective.

SALE BY STATE OF UNCLAIMED STOCK TREATED AS A SECTION 1033 DISPOSITION

Many states have unclaimed property laws, which allow institutions and others that hold property on behalf of people that cannot be located to turn that money over to the state. After a given period, the state will typically then sell the property and add the funds to its general funds (if the property is already cash or bank account proceeds, no sale is needed).

A partnership had an interest in an escrow account that owned shares of stock of a publicly traded company. A successor escrow agent, out of lack of knowledge, did not know how to return such stock to the rightful owner (the partnership) and turned it over to a state under its unclaimed property law. The state later sold the stock. At a later date, the partnership found about the stock and was able to be paid the sales proceeds from the stock.

The sale of the stock generated gains for the partnership (even though that sale occurred without its knowledge or consent). The partnership requested the IRS to advise whether it could make use of Code §1033. Code §1033 always a taxpayer to defer gain in regard to property that is compulsorily or involuntarily converted by reason of its destruction, theft, seizure, requisition or condemnation, into similar property (either directly or by conversion into money and then acquisition of replacement property within 2 years).

In a favorable ruling, the IRS reached the following interest conclusions:

a. The transfer of the funds into the state’s control was considered a “seizure” by the government, within the meaning of the statute;

b. The conversion of the stock into money was determined to compulsory or involuntary – i.e., beyond the taxpayer’s control – because the taxpayer did not intentional fail to exercise its ownership rights;

c. The two year replacement period did not start when the state sold the stock, but at the later date when the state made the funds from the sale available to the taxpayer (thus giving more time to the taxpayer to acquire related property); and

d. Allowing the taxpayer to replace the stock with stock of another publicly traded corporation – equating the risks and activities of one publicly traded stock held for investment with other publicly traded common and preferred stock and stock in publicly traded mutual funds (but not debt instruments).

PLR 200946006

IRS GETS HAMMERED IN TRANSFER PRICING CASE

Transactions between related companies are subject to special scrutiny under Internal Revenue Code section 482, which requires that amounts paid between the companies be based on the "arms length" prices that unrelated companies would charge each other. Special rules exist under the Treasury Regulations for transactions involving the transfer of intangible property, and a further subset of those rules provides for a method where two related companies (typically one inside the United States and one outside the United States) engage in cost-sharing to jointly develop intangible property.

These cost-sharing rules were recently involved in a major Tax Court case. In the case, a US corporation entered into a cost-sharing arrangement with an Ireland affiliate. Since the US corporation had already developed some intangible property that was to be used in the venture, the Ireland affiliate was required to make a "buy-in" payment to the US corporation to compensate it for the existing intangible property that the US corporation brought to the venture. The US corporation and the Ireland affiliate constructed what they determine to be a reasonable "arms length" price of $166 million for the "buy-in" based on transactions that the US corporation entered into with unrelated parties.

The IRS challenge that price, and said that the buying payment should be an astounding 15 times higher at $2.5 billion and allocated income for the difference to the US corporation. The case eventually found its way into the US Tax Court for resolution.

Coming up with an arms length price for goods and intangibles is a conceptual exercise, with a lot of wiggle room in real-world implementation. This wiggle room also opens the door to reasonable disagreements between IRS and taxpayer experts as to what an appropriate arms length price should be in any particular situation.

Typically, these matters are negotiated and settled somewhere between the taxpayers position and the IRS' position, or when the court has to decide the issue it usually settles on a price somewhere between the two extremes.

In this case, however, the Tax Court completely sided with the taxpayer. Further, the Tax Court further embarrassed the IRS with a finding that the IRS's determinations were arbitrary, capricious, and unreasonable.

One take away from the case is that even if the taxpayer adopts a reasonable arms length price, the risk always remains that the IRS may challenge that price and that challenge may be entirely unreasonable. Another take away, however, is that the Tax Court has no difficulties in disregarding such unreasonable IRS activity and noting it on the public record.

VERITAS Software Corporation, Symantec Corporation (successor in interest), 133 TC No. 14 (2009)

2 WITNESS RULE FOR LEASES [FLORIDA]

In a recent Florida case, a landlord and tenant entered into a 10 year lease. Each signed the lease, but no witnesses signed. The landlord sought to void the lease because the signatures of the parties were not witnessed by two witnesses.

Fla.Stats. §689.01 reads in part "How real estate conveyed.--No estate or interest of freehold, or for a term of more than 1 year, or any uncertain interest of, in or out of any messuages, lands, tenements or hereditaments shall be created, made, granted, transferred or released in any other manner than by instrument in writing, signed in the presence of two subscribing witnesses by the party creating, making, granting, conveying, transferring or releasing such estate, interest, or term of more than 1 year, or by the party's lawfully authorized agent, unless by will and testament, or other testamentary appointment, duly made according to law; and no estate or interest, either of freehold, or of term of more than 1 year, or any uncertain interest of, in, to, or out of any messuages, lands, tenements or hereditaments, shall be assigned or surrendered unless it be by instrument signed in the presence of two subscribing witnesses by the party so assigning or surrendering, or by the party's lawfully authorized agent, or by the act and operation of law."

At first reading, there is no mention of a lease in the statute. However, since a lease is considered a transfer of an interest in land, the statute applies and leases for more than 1 year require two signatures.

The case does not make new law on this issue, but since it is a nonobvious issue, it bears mentioning, especially for those that don't practice regularly in the real estate area.

The case also held that the 2 witness requirement was not overridden by Fla.Stats. §608.4235, which authorizes a transfer of an interest in real property by a limited liability company on the signature of any member and makes no mention of required witnesses.

Skylake Insurance Agency, Inc. v. NMB Plaza, LLC, 3rd DCA, Case No. 3D07-454, October 28, 2009

LEGISLATION FINALLY PASSED TO AVOID REPEAL OF ESTATE TAXES

Since the early days of George Bush, Jr.’s administration, 2010 has been out there as the year in which there will be no federal estate tax. Also since that time, we have been predicting for our clients that this would never come to pass, and that sometime before then the repeal would be repealed, and higher unified credit and lower maximum tax rates would be made permanent.

Politics being what they are, what Congress had 8 years to deal with is now on the front burner, with only a few weeks left in 2009 to take action. Of course, Congress could act sometime in 2010 on a retroactive basis to the change the law, but many in Congress are adverse to retroactive tax legislation on major issues.

For the first time, legislation has cleared at least one house of Congress to repeal the repeal. Last Friday, the House of Representatives passed a bill that would repeal the repeal of estate taxes in 2010, make permanent the $3.5 million unified credit applicable in 2009, and also make permanent the 2009 maximum federal estate tax rate of 45%. The legislation would also repeal the one year of carryover basis that is presently in the law for 2010.

The Senate has not yet passed a corresponding bill. Issues likely to arise in the Senate include the amount of the unified credit equivalent, whether to index that credit for inflation, the maximum tax rate, bringing the gift tax unified credit back in line with the estate tax unified credit, and portability of the unified credit between spouses.

Whether any bill will clear both houses of Congress before year end is anyone’s guess.

IRS REFUSES TO GIVE UP ON OVERSTATED BASIS STATUTE OF LIMITATIONS ISSUES

We have previously reviewed two cases that have held that a reduction in gain arising from an erroneous overstated tax basis in an asset is NOT an omission from gross income that can give rise to an extended six year statute of limitations for gross income omissions of 25% or more. Salman Ranch Ltd. et al. v. U.S., 104 AFTR 2d ¶ 2009-5190 (CA FC 7/30/2009); Bakersfield Energy Partners, LP, Robert Shore, Steven Fisher, Gregory Miles and Scott McMillan, Partners other than the Tax Matters Partner, 128 TC No. 17 (2007). Nonetheless, the IRS has refused to be cowed by these decisions.

In September, the IRS issued new Temporary Regulations that will treat such basis overstatements as omissions from gross income for this purpose (Reg. § 301.6501(e)-1T(a)(1) ,  Reg. § 1.6229(c)(2)-1T(a)(1) ,  T.D. 9466, 09/24/2009).  The IRS has further signaled its enthusiasm for this issue by issuing a directive to IRS attorneys litigating these issues to contact the Office of Associate Chief Counsel (Procedure and Administration) to coordinate responses to the issue in light of the new Temporary Regulations.

Apparently, the IRS intends to pursue these issues, even in jurisdictions with court decisions hostile to the IRS’ position. The Temporary Regulations were crafted to take advantage of language in cases that had previously ruled in favor of the IRS on the issue. Whether the adoption of Temporary Regulations will now convince courts in those jurisdictions that were previously hostile to the IRS’ position remains to be seen.

Chief Counsel Notice 2010-001