Virginia Kite, who died on April 28, 2004, was the daughter of a prominent banking family. Her father was the chairman of Vose Bank (which later became First National Bank & Trust Co. of Oklahoma City (FNB)). She was the beneficiary of many trusts, which held cash, founder’s shares and securities of FNB and its affiliates and other valuable assets. She was a smart businesswoman who managed not only her assets, but also her family’s finances. She was an active participant regarding her trusts and met with her trust administrator at least four times a year to discuss her investments.
Virginia married James, and they had three children. On Feb. 15, 1995, Virginia created the Kite Family QTIP Trust (QTIP Trust 1) as an irrevocable trust for the benefit of her husband, the sole income beneficiary during his life. She funded the trust with shares of common stock of Oklahoma Gas &Electric Co. On the date of the gift, the shares had a value of $4,246,075.60, which Virginia reported on her 1995 federal gift tax return. However, she deducted the gift as a marital deduction under Internal Revenue Code Section 2523 and as such, didn’t owe any federal gift tax on the transfer.
According to the terms of QTIP Trust 1, on James’ death, Virginia would be the sole income beneficiary during her life, and after her death, the trust corpus would be distributed into three separate trusts of equal value for each of her children.
James died one week after Virginia created QTIP Trust 1. The executor of James’ estate made an IRC Section 2056(b)(7) election for QTIP Trust 1, qualifying the trust property to pass to Virginia for the marital deduction.
On James’ death, his estate was transferred to his lifetime revocable trust (which became irrevocable on his death) except for certain tangible personal property that was transferred to Virginia. According to the terms of James’ lifetime revocable trust, the amount of his marital estateequal to the maximum generation-skipping transfer (GST) exemption would fund the Virginia V. Kite GST Exemption QTIP Trust (QTIP Trust 2). On James’ estate tax return, the executor made a Section 2056(b)(7) election for QTIP Trust 2, which qualified the trust property passing to Virginia for the marital deduction.
The balance of James’ estate funded the Virginia V. Kite Marital Trust (the marital deduction trust). The property qualified for the marital deduction, but was excluded from the Section 2056(b)(7) QTIP election. Instead, it qualified for the marital deduction under Section 2056(b)(5).
The remainder of James’ estate was distributed to the Virginia V. Kite GST Exemption Residuary Trust (the residuary trust) for Virginia’s benefit during her life and, after her death, to equal trusts for her three children. The amount reported on James’ federal estate tax return was $200,406; it wasn’t included in the marital deduction claimed by James’ estate.
A Partnership is Formed
Virginia, like James, also created a lifetime revocable trust (the revocable trust) that, on her death, directed the allocation of her trust estate between a GST exemption residuary share and a non-exempt residuary share. The trustees were to immediately divide the shares into three parts of equal value for Virginia’s children.
On Dec. 31, 1996, Virginia’s five trusts (the two QTIP trusts, the marital deduction trust, the residuary trust, and the lifetime revocable trust) formed Brentwood Limited Partnership (Brentwood) in exchange for limited partnership interests. Easterly Oklahoma, which was wholly owned by Virginia and her three children (either individually or through trusts), was the general partner of Brentwood. In 1997, Virginia, as trustee of her trusts, transferred to her children about one-third of her Brentwood interest, worth $4.5 million. She also transferred to her children some Easterly Oklahoma shares worth $30,600. On her 1997 federal gift tax return, Virginia reported the transfers as gifts, with a gift tax liability of $1,485,132.
Seeking a more favorable state tax jurisdiction, Brentwood and Easterly Oklahoma reorganized in Texas in 1998 as Baldwin Limited Partnership (Baldwin) and Easterly Texas, respectively. In May of that year, Virginia, through her trusts, sold her remaining interest in Baldwin to her children for $12,533,129.24 of secured, fully recourse promissory notes (Baldwin notes). The children agreed to make quarterly payments of principal and interest, which accrued at a rate of 5.81 percent per year from Aug. 1, 1998, through May 1, 2013. The principal and interest payments totaled approximately $1,063,784 each year. Virginia, as the current income beneficiary of her trusts, received the payments on the Baldwin notes.
A Family Investment Company
In December 2000, Virginia’s trusts contributed the Baldwin notes and Easterly Texas contributed 1 percent of the value to form Kite Family Investment Co. (KIC). Virginia’s trusts collectively held a 99 percent interest in KIC and Easterly Texas held a 1 percent interest in KIC. Virginia was the majority shareholder of Easterly Texas, which in turn was the manager of KIC. Virginia’s children continued to make all required payments of principal and interest on the Baldwin notes now held by KIC.
In 2001, Virginia, as trustee of the revocable trust, sold her interest in KIC to her children for three private annuity agreements, with the first payments due in 2011 (the annuity transaction). A family attorney presented the details of the annuity transaction to Virginia’s children at a meeting in January 2001. Describing the annuity transaction as an estate-planning tool, the children would begin payments to Virginia 10 yearsafter the effective date of the annuity agreements. If Virginia died within the 10-year deferral period, her annuity interest would end and her interest in KIC (and indirectly, her interest in the Baldwin notes) would be removed from her gross estate. If Virginia lived beyond the 10-year deferral period, her children would be personally liable for the annuity payments due.
Virginia agreed to the annuity transaction. After executing the private annuity agreements, her net worth was more than $3.5 million (held in her lifetime revocable trust), and she was the current income beneficiary of other trusts that held about $20.8 million of marketable securities. She consulted not only with her family and business advisors, but also with her physician who attested that she was in good health.
In March 2001, Virginia executed three documents that replaced the current trustees of the QTIP trusts and the marital deduction trust with her three children retroactively effective as of Jan. 1, 2001. Her children contemporaneously executed subsequent documents to terminate the QTIP trusts and the marital deduction trust effective Jan. 1, 2001. The assets in those trusts, which consisted of KIC general partnership interests, were transferred to Virginia’s lifetime revocable trust. After this transfer, Virginia’s lifetime revocable trust held a 99 percent interest in KIC. The next day, Baldwin contributed $13,684,136.13 of assets to KIC; in return, Baldwin received a 55.8215 percent general partnership interest in KIC. Virginia’s lifetime revocable trust and Easterly Texas owned KIC’s remaining interests, 43.7367 percent and under 1 percent, respectively. Virginia, as trustee of her lifetime revocable trust, never signed the amended and restated general partnership agreement.
In March 2001, Virginia’s lifetime revocable trust sold its entire remaining interest in KIC to Virginia’s children for three unsecured annuity agreements. The children each promised to pay $1,900,679.34 to Virginia’s lifetime revocable trust on March 30 of every year beginning in 2011 and ending on Virginia’s death. The children, Easterly Texas and Baldwin also entered into an amended and restated general partnership agreement to record their ownership interests in KIC.
Income and Estate Tax Returns
On Virginia’s 2001 through 2003 federal income tax returns, she reported income of $429,278, $654,962, and $302,176, respectively, and federal income tax of $77,371 (as amended), $118,357, and $1,460, respectively. Her 2004 final income tax return through her date of death reported income of $10,227 and no federal income tax due.
On April 28, 2004, Virginia died. Her children hadn’t made any annuity payments to her before her death. Her executor timely filed a federal estate tax return on Jan. 28, 2005, reporting a gross estate of $3,551,120 and a taxable estate of $2,281,517. Virginia’s transferred interests in the Baldwin notes or KIC weren’t included in her gross estate or adjusted taxable gifts.
The Internal Revenue Service issued two notices of deficiency: a $6,053,752 deficiency in Virginia’s federal gift tax for 2001 and a $5,100,493 deficiency in the estate’s federal estate tax. In Estate of Virginia V. Kite v. Commissioner, T.C. Memo. 2013-43(Feb. 7, 2013), the U.S. Tax Court was asked to determine: (1) whether the transfer of partnership interests to Virginia’s children in exchange for the private annuity agreements was a disguised gift subject to gift tax; (2) whether the transfer of the QTIP trust assets constituted a disposition of the qualifying income interest for life such that the disposition was a taxable gift of the remainder interest under IRC Section 2519;and (3) whether Virginia made a taxable transfer under IRC Section 2514 when she effectively released her general power of appointment over the corpus of her marital deduction trust.
The Court Speaks
A gift tax doesn’t apply to a transfer for full and adequate consideration in money or money’s worth. The parties disputed whether the transfer of the KIC partnership interests to Virginia’s children in exchange for the annuity agreements was made for adequate and full consideration. The IRS argued that the transfer was a disguised gift subject to gift tax; it claimed that the annuity agreements didn’t constitute adequate consideration because they were structured to make sure that no annuity payment would be made and there was no real expectation of payment. The estate, on the other hand, argued that the annuity transaction was for adequate and full consideration because the parties used IRS actuarial tables to properly value the annuities and the parties always intended to comply with the terms of the annuity agreements.
The court agreed with Virginia’s estate, that Virginia wasn’t precluded from relying on actuarial tables. The court referenced the letter from Virginia’s physician, which attested to Virginia’s health and longevity. The court even found unpersuasive the fact that Virginia hired 24-hour medical care beginning 2001, as evidence that Virginia had a terminal illness or an incurable disease. Rather, the court said, “Her decision to hire home health care was not unusual for a woman who was accustomed to hiring personal assistants,” and as such, the use of home health care merely “suggested” Virginia’s declining health.
The court also rejected the IRS’ argument that the annuity transaction was illusory: the annuity agreements between Virginia and her children were enforceable, and the parties demonstrated their intention to comply with the terms of the annuity agreements or, in Virginia’s case, to demand compliance. Citing Virginia’s business acumen, the court stated that it was unlikely Virginia would have entered into the annuity agreements unless they were enforceable and she could profit from them: “[B]ased on the unique circumstances of these cases and, in particular, Mrs. Kite’s position of independent wealth and sophisticated business acumen, the Court finds that the annuity transaction was a bona fide sale for adequate and full consideration.” Finally, the court noted that despite the flawed partnership agreement purporting to document Baldwin’s admission as a general partner of KIC, Virginia’s actions evidence the requisite intent affirming her diminished interest in KIC. She therefore didn’t maintain an indirect interest in KIC that would otherwise be included in her estate under IRC Section 2036. Consequently, the transfer of partnership interests to Virginia’s children in exchange for the private annuity agreements wasn’t subject to federal gift tax.
The IRS also argued that the transfer of the QTIP trust assets constituted a disposition of the qualifying income interest for life, such that the disposition was a taxable gift of the remainder interest under IRC Section 2519. When James died, his estate made an IRC Section 2056(b)(7) election to treat the marital deduction property passing to the QTIP trusts as QTIP assets. Virginia, as the surviving spouse, received a lifetime income interest in the trust assets. After her death, the trust assets were to be distributed into three separate trusts for her children. Under the QTIP regime, the QTIP trust assets underlying the marital deduction were to be subject to either gift tax under Section 2519 if Virginia disposed of the income interest during her lifetime or estate tax under IRC Section 2044 if she retained the income interest until her death. Virginia continued to receive the income interest from the QTIP trust assets that passed from Brentwood to Virginia’s trusts. Accordingly, she didn’t dispose of her qualifying income interest because she continued to have a qualifying income interest for life in the QTIP trusts after reinvestment of the trust assets. In 1998 and in 2000, Virginia, through her trusts, made three more transfers of the QTIP trust assets; but, because she maintained a qualifying income interest in the converted property, the transfers weren’t taxable under Section 2519. Similarly, the transfer of the Baldwin notes to KIC wasn’t taxable under Section 2519 because Virginia continued to have a right to all payments on the Baldwin notes. Thus, from 1996 through 2000, her transfers and reinvestments of the QTIP trust assets satisfied the requirements of the QTIP rules.
However, the liquidation of the QTIP trusts and subsequent sale of Virginia’s interests in KIC disregarded the QTIP rules. As a result, the sale of Virginia’s interest in KIC that can be traced to the QTIP trusts was subject to federal gift tax under Section 2519, to the extent of the fair market valueof the entire property subject to Virginia’ s qualifying income interest, determined on the date of the annuity transaction, less the value of her qualifying income interest. The court, however, stated that because Virginia received adequate and full consideration for her income interest in KIC, she didn’t make a gift of her qualifying income interest under Section 2511.
Finally, the court found that Virginia didn’t make a taxable transfer under Section 2514 when she effectively released her general power of appointment over the corpus of her marital deduction trust. The transfer of the trust assets to Virginia’s lifetime revocable trust wasn’t a transfer of property for gift tax purposes because she didn’t transfer an interest in the property to another. Instead, Virginia maintained her interest in the property as the grantor and the sole income beneficiary of her lifetime revocable trust. Therefore, she didn’t make a taxable transfer of the marital deduction trust assets under Section 2514.
The Tax Court agreed with most of Virginia’s estate’s arguments and upheld her extremely complex estate plan. Nonetheless, the court did find that the portions of the annuity value originally traceable to the ownership interest of QTIP Trust 1 and QTIP Trust 2 in KIC, less the value of Virginia’s qualifying income interests in QTIP Trust 1 and QTIP Trust 2, were subject to federal gift tax as of the simultaneous termination of the marital trusts and the transfer of the marital trust assets in 2001.