Taxpayers Can Reduce Value of Gift for Assumption of Code Section 2035(b) Estate Tax Liability.

(Parker Tax Publishing September 25, 2015)

The Tax Court held that a donor's daughters' assumption of a potential Code Sec. 2035(b) estate tax liability as a condition of a gift could be factored into calculating the fair market value of the gifted property for purposes of the gift tax. The court noted the assumption was a detriment to the daughters and a benefit to the donor such as would be considered by a willing buyer and willing seller in determining a sale price of the transferred property rights. Steinberg v. Comm'r, 145 T.C. No. 7 (2015).

In Steinberg v. Comm'r, 141 T.C. No. 8 (2013) (Steinberg I), the Tax Court had previously determined that it would no longer follow its decision in McCord v. Comm'r, 120 T.C. 358 (2003), rev'd, 461 F.3d 614 (5th Cir. 2006), in which it held that a couple had improperly reduced their gross gift value by the actuarial value of the donees' obligation to pay potential estate taxes. In Steinberg I, the court held that a willing buyer and a willing seller in appropriate circumstances could consider the donee's assumption of the Code Sec. 2035(b) estate tax liability when determining a sale price. The Tax Court then had to decide whether a net gift agreement is such an appropriate circumstance.

In another victory for taxpayers, in Steinberg v. Comm'r, 145 T.C. No. 7 (2015), the court agreed that an appropriate circumstance arises when the donee's assumption of the Code Sec. 2035(b) estate tax liability is a detriment to the donee and is a benefit to the donor. Additionally, the court also concluded that the fact that the estate tax payment was contingent rather than certain did not preclude use of the Code Sec. 7520 rates in valuing such payment.

Background

Jean Steinberg entered into a binding gift agreement with her four daughters under which she gave them property. In exchange, the daughters agreed to assume and to pay any federal gift tax liability imposed as a result of the gifts. The daughters also agreed to assume and pay any federal or state estate tax liability imposed under Code Sec. 2035(b) as a result of the gifts in the event that Steinberg passed away within three years of the gifts. 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. The daughters' agreement to assume the federal or state estate tax liability resulted in the gift agreement being a net gift agreement. Steinberg lived through the three-year period.

To determine the fair market value of the property rights she transferred pursuant to the net gift agreement, Steinberg hired William Frazier, a qualified appraiser. Frazier concluded that the aggregate value of the net gift on the date it was made, April 17, 2007, was approximately $71,600,000 He determined that the present value of the net gifts was the fair market value of assets conveyed by transfer from Steinberg less the liabilities (tax or otherwise) assumed by her daughters. According to the valuation, the payment by the daughters of their share of the estate taxes was a contingent liability and the probability of this liability could be calculated. Steinberg also reduced the fair market value of the properties by an amount representing the value of the daughters' assumption of the Code Sec. 2035(b) estate tax liability.

The IRS disallowed the discount for the daughters' assumption of the Code Sec. 2035(b) estate tax liability. According to the IRS, Frazier's valuation analysis was flawed because it failed to consider contingencies such as Steinberg's health and general medical prognosis. The IRS also argued that the daughters' assumption of the Code Sec. 2035(b) estate tax liability in the net gift agreement did not create any new burden on the daughters or benefit for Steinberg because the daughters would have had to bear the burden of the Code Sec. 2035(b) estate tax liability either under New York law or as beneficiaries of Steinberg's residuary estate. The IRS also said that Frazier incorrectly applied Code Sec. 7520 rates as the discount factor in calculating the value of the daughters' assumption of the contingent estate tax liability. Specifically, the IRS contended that the Code Sec. 7520 rates were not applicable because they apply only to annuities, life interests, terms of years, remainders, and reversionary interests.

Issues

The issues before the Tax Court were:

(1) whether a donee's promise to pay any federal or state estate tax liability that may arise under Code Sec. 2035(b) if the donor dies within three years of the gift should be considered in determining the fair market value of the gift, and

(2) if so, the amount, if any, that the promise to pay reduces the fair market value of the gift.

Tax Court's Opinion

The Tax Court held that the daughters' assumption of a potential Code Sec. 2035(b) estate tax liability was a detriment to the daughters and a benefit to Steinberg similar to what would be considered by a willing buyer and willing seller in determining the sales price of transferred property rights. Thus, the court concluded that the daughters' promise to pay any federal or state estate tax liability that might arise under Code Sec. 2035(b) if Steinberg died within three years of the net gift agreement should be considered in determining the fair market value of the gift.

With respect to the IRS's argument that Frazier's valuation analysis was flawed because it failed to consider contingencies such as Steinberg's health and general medical prognosis, the court said that Frazier took the possibility of Steinberg's death within three years of executing the net gift agreement into account because the daughters' liability for the Code Sec. 2035(b) estate tax was contingent on that possibility. And, the court noted, Frazier used the IRS's own mortality tables, which necessarily take some account of a person's health and general medical prognosis when arriving at a probability of death, to do so.

The court disagreed with the IRS's assertion that the net gift agreement duplicated New York law. The court noted that the IRS's argument was based on a New York State statute entitled "Apportionment of federal and state estate or other death taxes; fiduciary to collect taxes from property taxed and transferees thereof" and that the statute provided that a fiduciary may be required to pay estate tax with respect to any property required to be included in the gross estate unless the testator otherwise directs in his or her will that an amount of the tax will be equitably apportioned among the persons interested in the gross estate to whom property is disposed of. In such case, the court noted, those benefited must contribute the amounts apportioned against them. At the time of the gifts at issue, the Tax Court said, it was not possible to determine whether the N.Y. statute would apply to this case. When the gifts were made on April 17, 2007, the court observed, Steinberg was still alive and entirely capable of changing her domicile before her death. Thus, the court said, there was the possibility that the law of a state other than New York would apply to Steinberg's estate.

The court also noted that, at the time of the gifts, it was not possible to determine the provisions of Steinberg's will that would exist at the time of her death. As matter of law, Steinberg was entitled to change the provisions of her will before her death. At the time Steinberg and her daughters signed the net gift agreement, the court observed, there was no guaranty that the daughters would remain beneficiaries under Steinberg's residuary estate. The court therefore concluded that, because on the date of the gifts it was not certain that the law of New York or any other state would require the donees to pay ratable shares of the estate tax that might be incurred under Code Sec. 2035(b) on the gift tax paid with respect to the gifts, the provision of the net gift agreement that required the daughters to pay those shares of estate tax was not duplicative or illusionary.

Finally, with respect to the use of the Code Sec. 7520 rates to value the gift, the court concluded that the fact that the payment was contingent rather than certain did not preclude use of the Code Sec. 7520 rates. The IRS, the court said, had not persuaded it that there was a more appropriate method that should have been used. Thus, the valuation by Frazier was proper.

For a discussion of the effect a donee's assumption of estate or gift tax liability has on the fair market value of a gift, see Parker Tax ¶ 222,765. (Staff Editor 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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