Court Rejects IRS Attempts to Transform Trust Beneficiaries into Transferees Liable for Estate Tax. (Parker Tax Publishing June 8, 2012)

When an estate defaulted on almost $2 million of estate tax liability, the IRS went after the beneficiaries of a trust that had received distributions from the estate. In U.S. v. Johnson, 2012 PTC 131 (D. Utah 5/23/12), the IRS used multiple arguments in an attempt to transform the beneficiaries of the trust into transferees liable for the estate tax under the provisions of Code Sec. 6324(a)(2). In a very taxpayer-favorable and well reasoned decision, a Utah district court rebuffed the IRS and held that, while the trustees of the trust might be liable, the trust beneficiaries were not.

Facts

Anna Smith died testate on September 2, 1991. She was survived by her four children, whom she named as her heirs. Before her death, Anna executed a will and established the Anna Smith Family Trust. Two of her children, Mary Johnson and James Smith, were named as the personal representatives of the Anna's estate and were also the trustees of the Anna Smith Trust.

The will directed the personal representatives to pay Anna's debts as soon after her death as was reasonably convenient. While the will did not expressly direct the personal representatives to pay any federal estate tax levied against the estate, it stated that claims against the estate could be settled and discharged in the absolute discretion of the personal representatives. The will directed that the rest and residue of the estate be delivered to the trustees to be added to the principal of the Anna Smith Trust and administered in accordance with the provisions of the trust agreement.

The Anna Smith Trust was governed by a provision that stated that the trustees were to make certain specific distributions from the trust principal to several individuals as soon as possible after Anna's death. The trustees were also directed to pay any and all debts and obligations of the grantor (Anna), the last illness, funeral, and burial expenses of the grantor, and any state and federal income, inheritance, and estate taxes that may then be owing or that may become due and owing as a result of the grantor's death. After these distributions had been made, the trustees were to divide a third of the remaining trust corpus (not to exceed $1 million) into four equal parts to be distributed to four family limited partnerships, one of which had been established for each of the heirs. Finally, the trustees were directed to distribute the remaining principal and undistributed income of the trust equally to the heirs. The heirs also received benefits valued at nearly $370,000 from several life insurance policies belonging to Anna.

The trustees filed a federal estate tax return on June 1, 1992. The return valued Anna's gross estate at almost $16 million, with a federal estate tax liability of $6.6 million. The bulk of the estate consisted of 9,994 shares of stock in State Line Hotel, Inc., valued at $11.5 million. When the return was filed, the trustees elected to defer payment of a portion of the federal estate tax liability under Code Sec. 6166(a), which allows a deferral if more than 35 percent of an adjusted gross estate consists of an interest in a closely held business. The deferred tax liability was to be paid in 10 annual installments beginning on June 2, 1997, and ending on June 2, 2006. After receiving the estate tax return, the IRS properly assessed the estate for unpaid estate taxes on July 13, 1992.

On December 31, 1992, the trustees and heirs executed an agreement distributing all the remaining trust assets to the heirs.

With regard to the outstanding federal estate tax liability, the distribution agreement stated the following:

Each of the BENEFICIARIES acknowledges that the assets distributed to him or her will accomplish a complete distribution of the assets of the Trust. A portion of the total federal estate tax upon the Estate of Anna Smith is being deferred and is the equal obligation of the BENEFICIARIES to pay as the same becomes due. Likewise, if, upon audit, additional federal estate taxes or Utah inheritance taxes are found to be owing, the responsibility for any such additional taxes, interest or penalties will be borne equally by the BENEFICIARIES.

On May 30, 1995, the IRS issued a notice of deficiency against the estate, determining that the hotel shares were worth $15 million at the time of Anna's death. The adjusted valuation resulted in an alleged additional estate tax of $2.4 million. The estate contested the deficiency, and a settlement was ultimately reached where the estate agreed to pay additional federal estate taxes in the amount of $240,381. Thus, the total federal estate tax was almost $6.9 million.

In January 2002, the hotel filed for Chapter 11 bankruptcy in Nevada, and shortly thereafter, the court approved the sale of all the hotel's assets to a third party free and clear of all liens, claims, and encumbrances. The heirs received no value for their hotel shares, but each received $126,000 annually for signing a two-year non-compete agreement. The heirs also each reported losses in excess of $1 million in connection with their ownership of the hotel stock, which were used to offset taxable income.

In 2003, the estate defaulted on its federal estate tax liability, after having paid $5 million of the total amount due. In 2005, the IRS sent a notice and demand for payment of the tax liability to the estate and the personal representatives. Despite this notice and demand, the personal representatives failed to fully pay the assessments made against the estate. The IRS attempted to collect the taxes due through levies against the estate, the trust, and the trust beneficiaries but failed to yield any collections. The IRS instituted a suit in district court in an attempt to collect the outstanding estate tax liability from the estate's heirs.

Transferee Liability under Code Sec. 6324(a)(2)

Under Code Sec. 6324(a)(2), if the estate tax is not paid when due, then the spouse, transferee, trustee (except the trustee of an employees' trust that meets the requirements of Code Sec. 401(a)), surviving tenant, person in possession of the property by reason of the exercise, nonexercise, or release of a power of appointment, or beneficiary, who receives, or has on the date of the decedent's death, property included in the gross estate to the extent of the value, at the time of the decedent's death, of such property, is personally liable for the tax.

IRS's Arguments

The IRS claimed that each heir was liable for the estate tax under Code Sec. 6324(a)(2). According to the IRS, the heirs were transferees based on common law and Utah law. Under common law, the IRS argued, a transferee is anyone to whom a property interest is conveyed, and Utah law specifies that the creation of a trust involves the transfer of property interests in the trust subject-matter to the beneficiaries. Hence, according to the IRS, the heirs were transferees because a property interest in the trust corpus was conveyed to them upon the mere creation of the trust, and that property interest was held by the heirs at the time of the decedent's death.

The IRS also contended that the heirs were personally liable for the estate tax because they became transferees when property from the trust corpus was distributed to them.

The IRS also asserted that the heirs were beneficiaries under Code Sec. 6324(a)(2) and, citing Black's Law Dictionary, asserted that the a beneficiary is any person for whose benefit property is held in trust.

Finally, the IRS argued that if the personal liability assigned by Code Sec. 6324(a)(2) did not extend to trust beneficiaries, endless abuse and estate tax evasion would ensue.

Taxpayers' Arguments

The trustees admitted they fell within the scope of Code Sec. 6324(a)(2). Likewise, the heirs admitted that as beneficiaries of the decedent's life insurance proceeds, they also fell within the scope of Code Sec. 6324(a)(2) to the extent of the value of the insurance proceeds. With respect to the IRS's argument that the heirs became transferees when property from the trust corpus was distributed to them, the heirs argued that they could not be transferees because that property was not distributed to them immediately upon the date of the decedent's death. Thus, they denied all liability arising from their status as trust beneficiaries.

With respect to the IRS's assertion that the heirs were beneficiaries and thus liable under Code Sec. 6324(a)(2), the heirs conceded that they were beneficiaries of the decedent's life insurance policies and therefore liable for the value of the insurance proceeds distributed to them. However, they argued that the term beneficiary should not be interpreted broadly to mean any recipient of property from the decedent's gross estate.

District Court's Analysis

State Law Doesn't Control Application of Code Sec. 6324(a)(2)

The district court began its analysis by examining the IRS's argument that the heirs were transferees based on common law and Utah law because a property interest in the trust corpus was conveyed to them upon the mere creation of the trust, and that property interest was held by the heirs at the time of the decedent's death. The court noted that the Supreme Court has held that courts should look to state law to determine the scope of liability under some other sections of the tax law. However, the court stated, the same is not true for Code Sec. 6324(a)(2). Citing Schuster v. Comm'r, 312 F.2d 311 (9th Cir. 1962), the court noted that federal courts have developed a uniform body of federal law defining the nature and effects of Code Sec. 6324(a)(2) liability. Thus, examining state law was unnecessary because Code Sec. 6324 provides for the substantive liability of the transferees of estates with respect to the estate tax without regard to state law. While the IRS might be correct in its statement of Utah law, the court said, it's improper to rely on state law to define the term transferee for purposes of Code Sec. 6324(a)(2). The court therefore concluded that the heirs did not become transferees merely because they were named as trust beneficiaries when the trust was created.

Receipt of Trust Corpus Doesn't Convert Heirs into Transferees

The court then examined the IRS's contention that the heirs were personally liable for the estate tax because they became transferees when property from the trust corpus was distributed to them. Citing Englert v. Comm'r, 32 T.C. 1008 (1959) and Garrett v. Comm'r, T.C. Memo. 1994-70, the court noted that a transferee can only mean the person who, on the date of the decedent's death, receives or holds the property of a transfer made in contemplation of, or taking effect at, death. The district court said that the Englert court recognized that the language of Code Sec. 6324(a)(2) could be read in multiple ways because it imputes personal liability to a person who receives, or has on the date of the decedent's death, property included in the gross estate, and the syntax of the clause might suggest that Congress intended any transferee who receives property that had been in the gross estate, regardless of the time when he or she receives it, to be personally liable under Code Sec. 6324(a)(2). However, the district court noted, the Englert court held that Congress used the word receives to take care of property received by persons solely because of decedent's death such as insurance proceeds or property that was not in the possession of one of the persons described in Section 827(b) (i.e., the predecessor to Code Sec. 6324) at the moment of the decedent's death, but who immediately received such property solely because of the decedent's death.

Citing the Supreme Court's decision in Miller v. Standard Nut Margarine Co., 284 U.S. 498 (1932), the district court said that where there is ambiguity as to the meaning of a tax statute, the court must resolve the issue in favor of the taxpayer. Thus, the district court concluded that, because Code Sec. 6324(a)(2) may be interpreted in multiple ways, it is ambiguous and had to be interpreted in favor of the heirs. The district court concluded that for a person to be a transferee under Code Sec. 6324(a)(2), the person must have or receive property from the gross estate immediately upon the date of decedent's death rather than at some point thereafter.

Applying this interpretation, the district court said, case law supports that personal liability for an estate tax does not typically extend to trust beneficiaries because it is the trustee who receives the property on the date of a decedent's death. Instead, the court observed, it is the trustee who is personally liable for the payment of the federal estate tax under Code Sec. 6324(a)(2) since it was the trustee who received the property included in the decedent's gross estate and the trustee had the legal title, control, and possession of such property.

The court rejected the IRS's argument that the rationale behind the prior court decisions was limited to income beneficiaries. The district court cited the Eighth Circuit decision in Higley v. Comm'r, 69 F.2d 160 (8th Cir. 1934), where the court held that even though some trust beneficiaries may have an interest in the trust corpus itself, Congress chose to avoid having to determine which trust beneficiaries could bear the burden of personal liability for an estate tax by placing upon the trustee a personal liability. Further, contrary to the suggestion of the IRS, the court noted that the trust agreement did not give the heirs an immediate right to the balance of the corpus of the trust. Instead, the trustees were required to pay the expenses, debts, and obligations of the decedent, including any federal estate tax obligation, before any distribution of the trust property to the heirs.

The court said the second sentence of Code Sec. 6324(a)(2) also supported its conclusion that the heirs did not become transferees merely because they were named as trust beneficiaries when the trust was created. While that second sentence addresses special estate tax liens, which were not at issue in the case, the court stated that it was nevertheless relevant because it provides meaning about who a transferee is under the first sentence. The second sentence of Code Sec. 6324(a)(2) provides that any part of such property transferred by (or transferred by a transferee of) such spouse, transferee, trustee, surviving tenant, person in possession, or beneficiary, to a purchaser or holder of a security interest must be divested of the lien provided in Code Sec. 6324(a)(1) and a like lien must then attach to all the property of such spouse, transferee, trustee, surviving tenant, person in possession, or beneficiary, or transferee of any such person, except any part transferred to a purchaser or a holder of a security interest.

The court agreed with the heirs' argument that, because Congress referred to transferees of transferees in the second sentence of Code Sec. 6324(a)(2) and not the first sentence, that such subsequent transferees were not intended to be liable under the first sentence. According to the court, while it was conceivable that a transferee in the first sentence could be defined to mean an initial transferee of a decedent and any subsequent transferees, such a construction would render references to the transferees of any such person in the second sentence of the statute superfluous.

The Beneficiary Argument

With respect to the IRS's argument that the heirs were beneficiaries under Code Sec. 6324(a)(2), the court noted that the IRS did not contest the fact that multiple courts have interpreted beneficiary narrowly, such that it applies only to insurance policy beneficiaries. As the Tax Court outlined in its Garrett decision, the court said, the legislative history of Code Sec. 6324(a)(2) and its predecessors show that Congress was referring only to insurance beneficiaries when it used the term beneficiary in Code Sec. 6324(a)(2). Thus, the court concluded that it was clear that the term beneficiary was only meant to refer to insurance beneficiaries under Code Sec. 6324(a)(2) and not beneficiaries of a trust.

The Abuse Argument

Finally, the court addressed the IRS's argument that if the personal liability assigned by Code Sec. 6324(a)(2) did not extend to trust beneficiaries, endless abuse and estate tax evasion would ensue. To the district court, these concerns appeared overstated, since there was no question that trustees are personally liable under Code Sec. 6324(a)(2) when property included in a decedent's gross estate is transferred to a trust. Consequently, a trustee has every incentive to ensure that an estate tax owed by the estate was paid before distributing all the assets of the trust. The trustee's potential liability, the court stated, should help curb the abuses envisioned by the IRS. (Staff Contributor 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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