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Blank Spaces in Gift Documents Did Not Mean Decedent Retained Power to Alter Gifts
(Parker's Federal Tax Bulletin: February 1, 2013)

In Est. of Sommers v. Comm'r, T.C. Memo. 2013-8 (1/10/13), a physician gave artwork by way of interests in a limited liability company (LLC) to his nieces, then remarried his second wife, and then tried to get the artwork back. He died before the saga was over and his estate tried to argue that the existence of blank spaces in the gift documents, to be filled in at a later date, necessarily meant that the decedent retained the power to alter, amend, revoke, or terminate those gifts within the meaning of Code Sec. 2038. The estate's argument that the LLC units transferred by the decedent to the nieces were includible in his gross estate appeared to be motivated by a desire to minimize or eliminate the estate's gift tax liability and a belief that any resulting increase in the estate tax liability was unlikely to be significant.

The Tax Court rejected the estate's argument and instead interpreted the gift documents in the context of the overall agreement among the decedent and his nieces, which was for him to give his LLC units to them free of any obligation on his part to pay gift tax.

Facts

Sheldon Sommers was a successful physician in Indiana who owned a valuable art collection. Sheldon's wife of 45 years died in 1989 and he remarried in 1990. Sheldon divorced his second wife, Bernice, in 1997, but they remarried on June 23, 2002, and were still married when Sheldon died on November 1, 2002. Sheldon had no children from either marriage.

During his lifetime, Sheldon lived in both Indiana and New Jersey. At the time he divorced Bernice he was a resident of New Jersey. He moved back to Indiana in 1998 but returned to New Jersey in 2002 and was a New Jersey resident when he died. Sheldon had one sibling, a brother, Richard, who died in 2000. Richard had three daughters, who were Sheldon's closest living relatives.

In 2001, while living in Indiana, Sheldon hired Kristin Fruehwald, an attorney with Barnes & Thornburg (B&T), to advise him on the transfer of 12 works of art to his nieces. Sheldon arranged for the 12 art pieces to be moved from New Jersey to the nieces' respective homes in Indiana and Illinois. Sheldon and Ms. Fruehwald agreed that she would develop a plan whereby he could make the gifts of artwork to the nieces without incurring gift tax on the transactions. Sheldon told the nieces of his plans, and, at his request, they discussed the proposed gifts with Ms. Fruehwald, who told them to secure an appraisal of the 12 works of art. Ms. Fruehwald and the nieces also discussed having the nieces commit to pay any gift tax that might become due should the gifts exceed the then-applicable Code Sec. 2010(c)(3) basic exclusion amount of $675,000. The nieces had the art appraised and the appraisal report, dated September 10, 2001, reflected a combined value of $1,750,000, which was much higher than Ms. Fruehwald had anticipated.

Gift Plan

Having in mind Sheldon's goals of maintaining family control over, and preventing sales of, the 12 works of art and of avoiding gift tax on their transfer to the nieces, Ms. Fruehwald and another B&T tax attorney recommended the following giving plan to Sheldon. Sheldon and the nieces would form a limited liability company (LLC) to own the art. There would be an operating agreement that would include restrictions on member transfers of capital interests. Sheldon then would make gifts to the nieces, over a period of time, of his interests in the LLC. The attorneys explained to Sheldon that, if the artwork was owned by an LLC, subsequent gifts of minority interests in it would have a lower value than gifts of the artwork itself because the recipients could not freely resell the interests and would lack control of it.

B&T's proposed giving plan contemplated making gifts of LLC units to the nieces over more than one year so Sheldon could take advantage of both the increase, to $700,000, in the basic exclusion amount used in determining the unified credit that was scheduled to take place in 2002, and the multiple gift tax annual exclusions under Code Sec. 2503(b). The idea was for Sheldon to give the nieces, in 2001, LLC units in an amount not to exceed his "basic exclusion amount" ($675,000) plus the three $10,000 annual exclusions then available. He then would transfer any remaining value (in the form of LLC units) in 2002 or in a later year.

In December 2001, pursuant to the plan, (1) an Indiana LLC was established; (2) by bill of sale, Sheldon transferred the 12 works of art to the LLC, receiving in exchange voting and nonvoting capital units in it; and (3) Sheldon and the nieces signed an operating agreement governing the LLC, which placed restrictions on transfers of capital units, required unanimous member consent for many actions relating to management of the LLC and its assets (i.e., the art), and provided that all controversies among members had to be referred to mediation and, if that were not pursued or it failed to resolve the dispute, to arbitration. Sheldon owned 99 percent of the voting capital units and 98 percent of the nonvoting capital units in the LLC. The balance of both was acquired by the nieces, one-third each, for cash.

On December 27, 2001, Sheldon executed three documents entitled, "GIFT AND ACCEPTANCE OF CAPITAL UNITS," effective as of that date, each of which provided for the transfer of an unspecified number of voting and nonvoting capital units in the LLC to one of the nieces. Each niece also signed the document as "donee," accepting the units transferred to her. The documents left blank both the total number of voting and nonvoting capital units in the LLC and the number of such units transferred to each niece. Similarly, "Exhibit A" to each agreement, entitled, "Transfer Power," signed by Sheldon, left blank the number of voting and nonvoting capital units transferred by Sheldon to each niece.

On January 4, 2002, Sheldon and the nieces executed documents essentially identical to the December 27, 2001, documents, effective as of that date, except that there was no reference to the total number of voting and nonvoting capital units in the LLC. As in the case of the December 27, 2001, transfers, the documents left blank the actual number of such units transferred to each niece.

B&T lawyers explained to Sheldon that, until they received an appraisal valuing the interests in the LLC, the number of LLC capital units to be transferred to each niece had to be left blank and would be filled in on the basis of the appraisal report so as to avoid gift tax on the transfers.

On March 31, 2002, an appraisal set the net asset value of the LLC at $1,763,500 as of the two gift dates (December 27, 2001 and January 4, 2002). A B&T attorney computed the maximum number of LLC units to be transferred to the nieces under the original 2001 and 2002 gift documents. The computations revealed that the maximum number of LLC units that Sheldon would be able to transfer to the nieces in 2001 and 2002 without incurring any gift tax liability would leave Sheldon with 15.19 percent of the nonvoting capital units. The B&T attorneys then completed the original 2001 and 2002 gift documents by eliminating the blanks and identifying the interests transferred. In addition, they modified the original 2001 and 2002 gift documents in several respects, but none of the modifications affected the signature page of each document, which remained unchanged.

Second Thoughts about Gift

On April 5, 2002, Sheldon executed a new will in which he left his entire estate to Bernice. On June 4, 2002, Sheldon filed suit against his nieces claiming that there had been no effective gift or donation of the artwork to either the LLC or the nieces. An arbitrator concluded that Sheldon "did know that he was in effect gifting the artwork to the nieces, and that he intended to do what is reflected in the gifting documents." Subsequently, courts in both Indiana and New Jersey agreed with the arbitrator that completed gifts had been made.

Sheldon died on November 1, 2002.

Estate Tax Return

The Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, filed on behalf of Sheldon's estate included as one of the assets in the gross estate "artwork" valued at $1,750,000, with a footnote stating that litigation might change that valuation.

Previously, a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return for 2001, signed by Sheldon, and a Form 709 for 2002, signed by Bernice as executrix of Sheldon's estate, had been filed, which reflected the December 27, 2001, and January 4, 2002, transfers of LLC units to the nieces as taxable gifts (2001 and 2002 gifts). However, Sheldon's estate argued that those transfers did not constitute completed gifts for federal gift tax purposes.

IRS Arguments

The IRS argued that Sheldon's estate was precluded from denying that he made taxable gifts of his LLC units to the nieces, in part, on December 27, 2001, and, in part, on January 4, 2002, when he and the nieces signed the original 2001 and 2002 gift documents. The IRS relied on the fact that appellate courts in both Indiana and New Jersey affirmed decisions holding that Sheldon made irrevocable transfers of his LLC units on those dates. With respect to the December 27, 2001, transfer of LLC units, the IRS also argued that Sheldon's signing of the 2001 gift tax return reporting that transfer as a 2001 taxable gift constituted an admission that he ceded dominion and control of those interests (i.e., that he made a taxable gift thereof) in 2001.

The IRS argued in the alternative, that, if the Tax Court agreed with Sheldon's estate that his transfers of LLC units to the nieces were not completed gifts for federal gift tax purposes until the blanks on the original 2001 and 2002 gift documents were filled in and the completed documents delivered to the nieces on April 11, 2002, then Sheldon made taxable gifts of those interests in 2002.

Estate's Arguments

Sheldon's estate argued that the 2001 and 2002 gift documents, because they were incomplete when signed, did not effect completed gifts of the LLC units for federal gift tax purposes. Rather, because the 2001 and 2002 gifts were made in blank, Sheldon necessarily retained the power to alter, amend, revoke, or terminate those transfers, a power that he relinquished on April 11, 2002, by permitting B&T to deliver the completed gift documents to the nieces.

The estate cited Code Sec. 2038(a)(1), which includes in a decedent's gross estate interests in property transferred after June 22, 1936, where the transfer on the date of death was subject to change through the decedent's exercise of a power to "alter, amend, revoke, or terminate" the transfer, and to Code Sec. 2035(a), which requires the inclusion in a decedent's gross estate of property interests with respect to which the decedent relinquished, within three years of death, a Code Sec. 2038 power to alter, amend, revoke, or terminate the transfer thereof. On the basis of those provisions, the estate argued that the LLC units transferred to the nieces remained part of Sheldon's gross estate and that no gift taxes should therefore be imposed. According to the estate, the determination of a decedent's gross estate for federal tax purposes is governed by federal, not state, law, and pursuant to federal law there were no completed gifts of LLC units to the nieces on December 27, 2001, or January 4, 2002.

The estate also argued that the Indiana and New Jersey decisions did not collaterally estop the estate from arguing for the application of Code Sec. 2035 and Code Sec. 2038 in the instant case.

OBSERVATION: As the Tax Court noted, the estate's argument that the LLC units transferred by Sheldon to the nieces are includible in Sheldon's gross estate under Code Sec. 2035(a) and Code Sec. 2038(a)(1) appeared to be motivated by a desire to minimize or eliminate the estate's gift tax liability and a belief that any resulting increase in its estate tax liability was unlikely to be significant. That is because the estate believed that estate tax attributable to the inclusion of the LLC units in Sheldon's gross estate, unlike any additional gift tax payable by the estate, would be apportioned to the nieces as the recipients of the LLC units under New Jersey's equitable apportionment statute, thereby increasing the marital deduction for the balance of Sheldon's estate, which went to Bernice. Presumably, the Tax Court said, the estate feared a significant gift tax liability because: (1) it was possible that the Tax Court would find that the appraisal substantially undervalued the LLC units and the underlying art, and (2) the New Jersey court specifically found that the completed 2001 and 2002 gift documents made the nieces responsible for only the 2002 gift tax, meaning that an enhanced valuation of the LLC units that Sheldon gave to the nieces in 2001 would generate a substantial gift tax payable from the estate rather than no gift tax, which would be the case if the Tax Court adopted the appraisal valuation of the LLC units.

Nieces' Arguments

As intervenors in the case, the nieces argued that, on the basis of the Indiana and New Jersey state court decisions, the IRS was collaterally estopped from arguing that Sheldon failed to make completed gifts to the nieces for federal gift tax purposes on December 27, 2001, and January 4, 2002.

Tax Court's Decision

The Tax Court found that the Indiana and New Jersey state courts resolved the issue of whether Sheldon made a gift of the art work to his nieces in favor of the nieces and against the estate by finding that the 2001 and 2002 gifts were absolute and irrevocable and, therefore, not subject to alteration, amendment, revocation, or termination by Sheldon.

The Tax Court also concluded that Sheldon's estate was collaterally estopped by both the Indiana and New Jersey decisions from arguing (1) that the 2001 and 2002 gifts were not gifts for federal gift tax purposes, and (2) that, in making those gifts, Sheldon retained a Code Sec. 2038(a)(1) power to "alter, amend, revoke, or terminate" those gifts until that power was relinquished on April 11, 2002.

Finally, the Tax Court concluded that Sheldon made taxable gifts to the nieces on December 27, 2001, and January 4, 2002, and did not retain the power to "alter, amend, revoke, or terminate" those gifts within the meaning of Code Sec. 2038. As a result, the LLC units were not includible in Sheldon's gross estate.

(Staff Editor at Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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