Craig and his sister were the two remaindermen that succeeded to his parents’ property at the termination of 10 year QPRTs that the parents set up. Craig wanted to transfer his remainder interest in the property to his sister when the QPRTs terminated. His attorney told him he could disclaim his QPRT interests, and that his interests would pass to his sister without gift tax. Thus, he entered into disclaimers to accomplish this.
Oops! After doing the disclaimers, he learned that the nine month period for doing a qualified disclaimer for gift tax purposes ran from the time of establishment of the QPRTs (well, actually from the time when Craig became an adult after the QPRTs were established), and not from the 10 year termination date of the QPRTs. Therefore, his disclaimers were done too late. As nonqualified disclaimers, they transferred his interests to his sister under state law, but resulted in a taxable gift by him to his sister since they were not qualified disclaimers under Code Section 2518. The IRS sought to impose gift taxes.
That would seem to be the end of the story. However, resourceful Craig learned that under applicable Massachusetts law, a written instrument may be reformed or rescinded in equity on the grounds of mistake when there is “full, clear, and decisive proof” of the mistake. Craig thus brought an action to rescind the disclaimers.
While the action commenced in state court, it was eventually removed to federal court. Applying Massachusetts law, the court allowed the rescission.
Could it be that simple? Could a state law rescission of a transaction eliminate the federal transfer tax consequences that arose on the original transfer prior to its rescission? The IRS claimed that while the rescission may be binding for state law purposes, it could not undue the original gift tax consequences of the disclaimer transfer.
Clearly, the government has a valid concern that rescissions that eliminate taxable gifts can be problematic, since there often will not be an adverse party at the court proceeding that would inhibit collusive agreed rescissions between the parties that are entered into to avoid gift taxes. Indeed, there are a number of court decisions that will disregard a rescission for these purposes, at least when the government is not a party to the rescission proceedings.
Nonetheless, Craig was able to persuade the federal District Court that under his facts, the taxable gift was eliminated. The key facts that appear to have persuaded the Court were (a) the rescission action was heard by a federal court, not a state court, and (b) the IRS was a party to the action, thus eliminating the risk of collusion by the private parties.
The case instructs us that if a taxable transfer was the result of a transfer only undertaken by a mistaken belief that the transfer was free of gift tax, and if state law allows for rescission due to mistake, it may be possible to unwind the taxable transfer. However, to accomplish this, it will likely be necessary to find a procedural route that brings the IRS in as a party.
Breakiron v. Gudonis, 106 AFTR 2d 2010-XXXX (DC MA), 08/10/2010