Tax Court Reverses Course on Gift Tax Issue (Parker Tax Publishing: October 9, 2013)

In a recent case, the Tax Court determined that it would no longer follow its decision in McCord v. Comm'r, 120 T.C. 358 (2003), a case in which it held that a couple had improperly reduced their gross gift value by the actuarial value of the donees' obligation to pay any potential estate taxes that might result under Code Sec. 2035(b) if the couple was to die within three years of the gift.

In Steinberg v. Comm'r, 141 T.C. No. 8 (9/30/13), the taxpayer gifted securities and cash to her daughters and, in exchange, the daughters agreed to assume and pay, among other things, any estate tax liability imposed under Code Sec. 2035(b) as a result of the gifts. The Tax Court rejected the IRS's request for summary judgment and held that, because the value of the obligation assumed by the daughters was not barred as a matter of law from being consideration in money or money's worth, the fair market value of mother's taxable gift could possibly be reduced by the daughters' assumption of the potential Code Sec. 2035(b) estate tax liability.

Facts

At age 89, Jean Steinberg entered into a binding net gift agreement with her four adult daughters. In the net gift agreement, she agreed to make gifts of cash and securities to the daughters. In exchange, the daughters agreed to assume and to pay any federal gift tax liability imposed as a result of the gifts. They also agreed, in the event their mother passed away within three years of the gifts, to assume and to pay any federal or state estate tax liability imposed under Code Sec. 2035(b) as a result of the gifts. The agreements were the result of months of negotiations and the mother and daughters had separate attorneys.

Ms. Steinberg retained an appraiser to calculate the gross fair market value of the property transferred to her daughters. The appraiser also calculated the aggregate fair market value of the net gift. The appraiser determined the value of the net gift by reducing the fair market value of the cash and securities by both (1) the gift tax the donees paid, and (2) the actuarial value of the donees' assumption of potential Code Sec. 2035(b) estate tax. The appraiser determined the actuarial value of the donees' assumption of the potential Code Sec. 2035(b) estate tax by calculating Ms. Steinberg's annual mortality rate for the three years after the gift (i.e., the probability that she would pass away within one year, two years, or three years of the gift), among other things. The appraiser determined that the aggregate fair market value of the net gift was almost $72 million, as of the date of the gift.

On her gift tax return, Ms. Steinberg reported the appraiser's value as the taxable gift amount and calculated a total gift tax of $32 million. She attached a summary of the net gift agreement, which included a description of the appraiser's determination of the value of the net gifts, to the Form 709. Upon auditing the gift tax return, the IRS disallowed the discount for the assumption of the potential Code Sec. 2035(b) estate tax liability and assessed an additional $1.8 million of gift taxes.

The IRS did not dispute (1) the value of the cash and securities transferred; (2) whether Ms. Steinberg properly reduced her gift tax liability by the amount of gift tax her daughters assumed; or (3) whether the daughters' assumption of the Code Sec. 2035(b) estate tax liability was enforceable under local law. The IRS's sole claim was that the assumption of the potential Code Sec. 2035(b) estate tax liability by the daughters did not increase the value of Ms. Steinberg's estate and therefore did not constitute consideration in money or money's worth within the meaning of Code Sec. 2512(b).

Before the Tax Court, the IRS asked for summary judgment. It argued that the daughters' assumption provided no benefit (monetary or otherwise) to Ms. Steinberg other than some peace of mind. The IRS thus claimed that the daughters' assumption failed to replenish Ms. Steinberg's estate and therefore failed as consideration for a gift under the estate depletion theory of the gift tax. The IRS relied, in part, on the Tax Court's holding in McCord v. Comm'r, 120 T.C. 358 (2003), which was reversed and remanded in Succession of McCord v. Comm'r, 461 F.3d 614 (5th Cir. 2006).

The IRS also argued that the daughters' assumption of the potential Code Sec. 2035(b) estate tax liability was itself a gift because (1) the net gift agreement was between family members, and (2) the net gift agreement was not in the ordinary course of business. Further, it claimed that no part of the net gift agreement was bona fide, at arm's length, and free from any donative intent.

Determining the Tax Value of a Gift

The aggregate value of taxable gifts made during the year, among other things, determines the amount of gift tax on those gifts. Under Code Sec. 2512(a), the amount of a gift of property is generally the value of the property on the date the gift is complete. The gift is complete when the property has left the donor's dominion and control. Under Reg. Sec. 25.2512-1, the value of the property is the price at which it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts. If consideration is received for the gift, the amount of the gift is the amount by which the value of the property transferred exceeds the value of consideration received in money or money's worth. Thus, if a donor makes a gift subject to the condition that the donee pay the resulting gift tax, the amount of the gift is reduced by the amount of the gift tax. This is referred to as a net gift.

OBSERVATION: The net gift rationale flows from the basic premise that the gift tax applies to transfers of property only to the extent the value of the property transferred exceeds the value in money or money's worth of any consideration received in exchange. When a net gift occurs, the donor calculates his or her gift tax liability by reducing the amount of the gift by the amount of the gift tax. The rationale is that because the donee incurred the obligation to pay the tax as a condition of the gift, the donor did not have the intent to make other than a net gift. In other words, the donor reduces the value of the gift by the amount of the tax because the donor has received consideration for a part of the gift equal to the amount of the applicable gift tax.

Under Reg. Sec. 25.2512-8, to qualify as consideration in money or money's worth, the consideration received must be reducible to value in money or money's worth; consideration consisting of something unquantifiable, such as love and affection or the promise of marriage, is wholly disregarded. The estate depletion theory of gift tax has been applied to determine what constitutes consideration in money or money's worth. Under the estate depletion theory, which the Supreme Court cited in Comm'r v. Wemyss, 324 U.S. 303 (1945), a donor receives consideration in money or money's worth only to the extent the donor's estate has been replenished. Thus, the benefit to the donor in money or money's worth, rather than the detriment to the donee, determines the existence and amount of any consideration offset in the context of an otherwise gratuitous transfer.

Code Section 2035(b)

Under Code Sec. 2035(b), a decedent's gross estate is increased by the amount of any gift tax paid by the decedent or the decedent's estate on any gift made by the decedent during the three-year period preceding the decedent's death. For purposes of this gross-up provision, the phrase gift tax paid by the decedent or the decedent's estate includes gift tax attributable to a net gift the decedent made during that period (despite the fact that the donee is responsible for paying the gift tax in such situation).

OBSERVATION: Congress enacted Code Sec. 2035(b) as part of an effort to mitigate the disparity in treatment between the taxation of lifetime transfers and transfers at death. Congress imposed the gross-up provision on gift tax paid within three years of death because the gift tax paid on a lifetime transfer that is included in a decedent's gross estate is taken into account both as a credit against the estate tax and also as a reduction in the estate tax base, so substantial tax savings could be achieved under prior law by making so-called deathbed gifts, even though the transfer was subject to both taxes. Congress intended the gross-up rule to eliminate any incentive to make deathbed transfers to remove an amount equal to the gift taxes from the transfer tax base.

The McCord Decision

In McCord, a husband and wife made gifts to their sons and the sons agreed to be liable for all transfer taxes (federal gift, estate, and generation-skipping transfer taxes and any resulting state taxes) imposed on the couple as a result of the gifts. The couple reduced the gross value amounts of their respective shares of the gifts by the amount of federal and state gift tax generated by the transfer, which the four sons had agreed to pay as a condition of the gifts. The couple further reduced that gross value amount by the actuarially determined value of the four sons' contingent obligation to pay any estate tax that would result from the transaction if the couple were to pass away within three years of the valuation date. The IRS determined, among other things, that the couple had improperly reduced the gross value of the gifts by the actuarial value of the four sons' obligation to pay any potential estate taxes arising from the transactions.

The Tax Court agreed and held that in advance of the death of a person, no recognized method existed for approximating the burden of the estate tax with a sufficient degree of certitude to be effective for federal gift tax purposes. The court reasoned that the taxpayers' computation of the mortality-adjusted present value of the sons' obligation merely demonstrated that if one assumes a fixed dollar amount to be paid, contingent on a person of an assumed age not surviving a three-year period, one can use mortality tables and interest assumptions to calculate the amount that an insurance company might demand to bear the risk that the assumed amount has to be paid. The court further noted that the dollar amount of a potential liability to pay the Code Sec. 2035 tax was by no means fixed; rather, such amount depended on factors that were subject to change, including estate tax rates and exemption amounts (not to mention the continued existence of the estate tax itself). The Tax Court thus concluded that the taxpayers were not entitled to treat the mortality-adjusted present values as consideration received for the gifts.

Additionally, the Tax Court suggested that the taxpayers' reduction of the value of their gift failed under the estate depletion theory. The court pointed out that a donee's assumption of gift tax liability resulting from a gift provides a benefit to the donor in money or money's worth that is readily apparent and ascertainable, since the donor is relieved of an immediate and definite liability to pay such tax. According to the court, if that donee further agrees to pay the potential Code Sec. 2035(b) tax that may result from the gift, then any benefit in money or money's worth from the arrangement arguably would accrue to the benefit of the donor's estate (and the beneficiaries thereof) rather than the donor, and that the donor in that situation might receive peace of mind, but that is not the type of tangible benefit required to invoke net gift principles.

The Fifth Circuit reversed and remanded McCord, holding, among other things, that there was nothing too speculative about the McCord sons' legally binding assumption of the potential Code Sec. 2035(b) estate tax at the time of the gift. The court noted that it was axiomatic contract law that a present obligation may be, and frequently is, performable at a future date. It was also axiomatic, the court noted, that responsibility for the future performance of such a present obligation may be either firmly fixed or conditional, i.e., either absolute or contingent on the occurrence of a future event, i.e., a condition subsequent. And, the court said, it was axiomatic that any conditional liability for the future performance of a present obligation is to a greater or lesser degree speculative. The issue in McCord, the Fifth Circuit said, was not whether Code Sec. 2035's condition subsequent was speculative, but whether it was too speculative to apply.

According to the Fifth Circuit, there are three major types of conditions subsequent along the speculative continuum: (1) a future event that is absolutely certain to occur, such as the passage of time; (2) a future event that is not absolutely certain to occur but nevertheless may be a more certain prophecy; and (3) a possible, but low-odds, future event, which is undeniably a less certain prophecy.

Tax Court's Analysis

The Tax Court began its analysis by noting that the fundamental question posed was the fair market value of the property rights transferred under the net gift agreement. The court observed that all relevant facts and elements of valuing a gift at the time the gift is made had to be considered and that the willing buyer/willing seller test required the court to determine what property rights were being transferred and on what price a willing buyer and a willing seller would agree for those property rights.

The Tax Court agreed with the conclusion of the Fifth Circuit in Succession of McCord that a willing buyer and a willing seller in appropriate circumstances would take into consideration a donee's assumption of potential Code Sec. 2035(b) estate tax liability in arriving at a sale price and, thus, the value of a gift. Saying that it would no longer follow its prior holding in McCord v. Comm'r, 120 T.C. 358 (2003), the Tax Court held that, because the value of the tax obligations assumed by the donees is not barred as a matter of law from being consideration in money or money's worth within the meaning of Code Sec. 2512(b), the fair market value of donor's taxable gift could be determined with reference to the donees' assumption of the potential Code Sec. 2035(b) estate tax liability.

The court noted that the issue at hand was whether Ms. Steinberg would survive three years after the date of the gift. According to the court, this is a simple contingency based on the possibility of survivorship, rather than a complex contingency based on multiple occurrences. So the court had to determine whether Ms. Steinberg's survival three years after the date of the gift was speculative and, if so, whether it was too speculative or too highly remote to place a value on. The court held that the IRS failed to show as a matter of law that the daughters' assumption of Ms. Steinberg's potential Code Sec. 2035(b) estate tax liability could not be consideration in money or money's worth within the meaning of Code Sec. 2512(b). As a result, the court determined that the daughters' assumption of potential Code Sec. 2035(b) estate tax liability could possibly be quantifiable and reducible to monetary value.

With respect to the estate depletion theory, the court noted that in McCord it suggested that the sons' assumption of the potential Code Sec. 2035(b) estate tax failed as consideration for a gift under the estate depletion theory. In particular, the court pointed out in McCord that any benefit in money or money's worth that might arise from a donee's assumption of potential Code Sec. 2035(b) estate tax arguably would accrue to the benefit of the donor's estate (and the beneficiaries thereof) rather than the donor. The Tax Court said that its distinction in McCord between a benefit to the donor's estate and a benefit to the donor was incorrect. For purposes of the estate depletion theory, the court said, the donor and the donor's estate are inextricably bound. According to 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. A donee's assumption of potential Code Sec. 2035(b) estate tax liability, the court said, may provide a tangible benefit to the donor's estate, and therefore as a matter of law it could meet the requirements of the estate depletion theory.

Finally, the Tax Court found the IRS's claim that a transfer between family members is necessarily a gift unless it is in the ordinary course of business to be erroneous. A transfer between family members that is not in the ordinary course of business may still avoid gift tax to the extent it is made for consideration in money or money's worth, the court said. Thus, a transfer not in the ordinary course of business may still avoid gift tax to the extent it is made for full and adequate consideration, regardless of whether the transfer was between family members. Further, the court noted, there was nothing in the record to indicate that the net gift agreement was not bona fide or made at arm's length. Ms. Steinberg and her daughters, the court observed, were represented by separate counsel, and the net gift agreement was the culmination of months of negotiation.

As a result of the above, the Tax Court held that there were genuine disputes of material fact as to whether the daughters' assumption of Ms. Steinberg's potential Code Sec. 2035(b) estate tax liability constituted consideration in money or money's worth. The court thus rejected the IRS's request for summary judgment on this issue.

Parker Tax Publishing Staff Writers

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