• Gift taxes on net gift made by relinquishment of income interest in QTIP trust included in gross estate under Internal Revenue Code Section 2035(b)—In Estate of Anne W. Morgens v. Commissioner, 133 T.C. 402, (May 3, 2012), the Tax Court addressed whether gift tax paid by a trust under a net-gift arrangement could be includible in the donor/decedent’s estate under IRC Section 2035(b).
Anne Morgens survived her husband and was the beneficiary of a qualified terminable interest property (QTIP) trust he established. This QTIP trust was ultimately divided into two trusts, Trust A, worth approximately $8.3 million, and Trust B, worth over $28 million. Initially, Anne maintained her beneficial interest in both trusts, and the division didn’t result in any tax consequences. However, in December 2000, a little less than a year after her husband’s death, she relinquished her income interest in Trust A.
This action triggered a gift tax on the deemed transfer of the remainder interest in Trust A to the remainder beneficiaries (her descendants) under IRC Section 2519(a). When a spouse beneficiary transfers all or part of a QTIP’s qualifying income interest, she’s deemed to transfer the entire QTIP property under IRC Section 2519, except the qualifying income interest, which is an ordinary gift under IRC Section 2511.
The accelerated remainder interest in Trust A was valued at $6,398,901. However, Anne made this transfer as a net gift in which the beneficiaries were responsible for the gift tax. She filed a gift tax return reporting a net taxable gift of $4,111,592. Similarly, the trustees of Trust A paid the $2,287,309 in gift tax to the Internal Revenue Service.
A little over a year later, Anne made a similar gift by relinquishing her income interest in Trust B. The gross value of the accelerated remainder interest in Trust B was $21,676,289. The gift tax return reported a net gift of $13,983,787. Again, the trustees of Trust B paid the gift tax, in this case $7,692,502.
A year and a half after the second gift, Anne died. The estate tax return filed by her estate didn’t include the gift taxes paid on the 2000 and 2001 gifts as part of her gross estate. The IRS issued a notice of deficiency based on the failure to include the gift tax in the gross estate, and the estate petitioned the Tax Court for a redetermination.
IRC Section 2035(b) provides that:
The amount of the gross estate (determined without regard to this subsection) shall be increased by the amount of any tax paid under chapter 12 by the decedent or his estate on any gift made by the decedent or his spouse during the 3-year period ending on the date of the decedent’s death.
The estate argued that the gift tax wasn’t paid by the decedent, because the transfers were net gifts. Since the trustees of the trusts paid the gift taxes, the estate argued, the gift taxes weren’t “paid by …. the decedent,” as is required by Section 2035(b) for such taxes to be included in the gross estate.
The Tax Court disagreed. It held that it was bound by precedent (Estate of Sachs v. Comm’r, 88 T.C. 769 (1987), aff’d in part and rev’d in part, 856 F.2d 1158 (8th Cir. 1988)) to treat Anne as having paid the gift tax on a net gift because the tax liability was ultimately hers, even if she transferred the liability by contract to the trustees. Furthermore, the court explained, the purpose of Section 2035(b) is to prevent deathbed transfers from decreasing the taxable estate. Since all of the assets of the trusts would have been included in Anne’s estate if the gift hadn’t been made, it makes sense to include the gift tax paid by the trustees in her estate for the same purpose. It further held that the language of IRC Section 2207A supported this reasoning. That section allows a donor who has made a gift under IRC Section 2519 to recover the gift tax from the donee. The court noted that Section 2207A doesn’t shift liability for the tax, but merely allows the donor (who remains fully liable for the tax) to recover the payment from the other party.
• Gifts of LP units qualify for gift tax annual exclusion—In Estate of George H. Wimmer v. Comm’r, T.C. Memo. 2012-157 (June 4, 2012), the Tax Court issued a memorandum opinion holding that a gift of limited partnership (LP) interests qualified for the gift tax annual exclusion. The holding was based on a very specific set of facts, but is the first case since Hackl v. Comm’r, 118 T.C. 279 (2002), aff’d, 335 F.3d 664 (7th Cir. 2003), to allow annual exclusions for gifts of limited liability company (LLC) or partnership interests.
George Wimmer and his wife, Ilse, formed a family partnership, each as trustees of their respective revocable trusts. At all times after funding, the partnership only owned publicly traded and dividend-paying stock. The purpose of the partnership was to increase family wealth, control the division of family assets, restrict nonfamily rights to the property and transfer property to younger generations without fractionalizing the assets. The Wimmers gave LP interests to their children and a trust for their grandchildren and reported some or a portion of the gifts as qualifying for the gift tax annual exclusion.
The partnership received dividends from the stock and made distributions to its limited partners each year, in proportion to their partnership interests. In addition, the limited partners had access to capital account withdrawals, which they used for their benefit, including paying down residential mortgages.
After George’s death, the IRS determined a deficiency in gift tax related to the gifts, asserting that the gifts didn’t qualify for the annual exclusion.
For a gift to qualify for the annual exclusion under IRC Section 2503(b), it must be a gift of a present interest, which Treasury Regulations Section 25.2503-3(b) defines as “an unrestricted right to immediate use, possession, or enjoyment of property or the income from property.” Under Hackl, the “use, possession or enjoyment” of: (1) the property, or (2) its income, must confer on the donee a “substantial present economic benefit.”
The Tax Court determined that because the partnership agreement imposed transfer restrictions on the LP interests, the donees didn’t have the “use, possession or enjoyment” of those interests because they weren’t freely alienable.
The next question was whether the donees had the “use, possession or enjoyment” of the income from the property. Under Hackl and Price v. Comm’r, T.C. Memo. 2010-2, to have the “use, possession or enjoyment” of income from gifted property, the taxpayer must prove that: (1) the property (that is, the partnership interest) would generate income; (2) some portion of the income would flow steadily to the donees; and (3) that portion of income could be readily ascertained. The Tax Court held that all these tests were met because the partnership held dividend-paying publicly traded stocks and the general partners were under a fiduciary duty to the limited partners, which obligated them to distribute at least a portion of the income to the limited partners to satisfy their income tax liabilities (noting that one of the partners was a trust of which the sole asset was the partnership interest, so that it had no other source of income to pay its income tax liability). Also, because the stocks were publicly traded and all distributions had to be made pro rata, the partners could estimate their allocation of the quarterly dividends based on the divided history and their percentage ownership.
The partnership agreement’s provisions regarding income distributions were critical to the decision. The opinion notes in a footnote that unlike the taxpayers in Hackl and Price, the general partner of the Wimmer partnership made distributions each year of net cash flow (defined as cash on hand after payments of then-due debts, prepayment of debts, reserves held for reasonably necessary expenses and future investment) that the partnership agreement required to be made to the partners in proportion to their respective percentage interests. In Hackl, the LLC operating agreement provided that the manager may distribute available cash (after paying expenses and debts and keeping a capital reserve). In Price, the general partner distributed profits in his discretion, unless directed otherwise by a majority of all partners, and the partnership agreement described distributions as secondary to the primary purpose of achieving long-term returns. In Price, no distributions of income were made to the limited partners in the relevant years, either.
The dividend-paying stock was also a key factor. Wimmer, in this regard, is quite distinct from the other cases, particularly Fisher v. U.S., 105 A.F.T.R.2d 2010-1347 (March 11, 2010). In Fisher, the taxpayers made gifts of interests in an LLC, which only owned undeveloped land. The Fishers argued that the children who received the LLC interests: (1) had an unrestricted right to receive distributions from proceeds of the sale of a capital asset; (2) had an unrestricted right to enjoy the land that was owned by the LLC; and (3) could unilaterally transfer their LLC interests. However, the Tax Court found these rights too contingent and granted the IRS’ motion for summary judgment denying the annual exclusion. Similarly, in Hackl, the LLC’s asset consisted of a tree farm that operated at a loss and generated no income. In Price, the partnership owned commercial real estate that generated income, but, as noted above, no distributions were made to the partners in the years in question.
Interestingly, a footnote in the Wimmer opinion states that the parties stipulated that the gifts of partnership interests to the trust, which granted Crummey rights to the
beneficiaries, would qualify as annual exclusion gifts to the trust beneficiaries if the court held that the gifts of LP interests qualified. The IRS apparently conceded that the added layer of a Crummey right within a trust wouldn’t interfere with the annual exclusion.