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