• Private annuity transaction deemed sale of interest in QTIP trusts under Internal Revenue Code Sec-
tion 2519—
In Estate of Virginia Kite v. Commissioner,
T.C. Memo. 2013-43 (Feb. 7, 2013), the Tax Court addressed the tax consequences of a series of transactions involving marital trusts for the benefit of Virginia Kite. Three trusts were at issue. The first was a qualified terminable interest property (QTIP) trust that Virginia established during her life for her husband, which continued for her own benefit after his death. The second was a QTIP trust that her husband established for her on his death. The third was a general power of appointment (GPA) marital trust established by her husband on his death.

These three trusts, along with other trusts established by Virginia and her husband, including her lifetime revocable trust, invested in a limited partnership (the first partnership). At a later date, the trusts sold Virginia’s remaining interests in the partnership to her children for over $12 million. The children paid for the partnership interests by issuing secured, fully recourse promissory notes, which required quarterly payments of principal and interest. As the income beneficiary of the trusts, Virginia received the payments (over $1 million each year) on the notes.

A few years later, the trusts contributed the interests in the notes to another limited partnership (the note partnership). As a result, Virginia’s trusts held a
99 percent interest in the note partnership (a corporation held the 1 percent general partnership interest). Her children continued to make all the required payments on the notes. 

At that time, the family also coordinated a sale of Virginia’s interests in the note partnership to her children in exchange for a private annuity. First, Virginia appointed her children as trustees of the three marital trusts. As trustees, her children terminated the trusts and distributed the trust property (the 99 percent interest in the note partnership) to Virginia’s revocable trust. Two days later, her revocable trust sold its entire interest in the note partnership to the children for three unsecured annuity agreements, in which each child promised to pay almost $2 million per year to Virginia’s revocable trust, beginning in 10 years and ending on Virginia’s death. The private annuity would require payments to Virginia 10 years from the date of the sale. If she died within the 10-year period, no payments would be due, her annuity interest would terminate and the value of her interest in the partnership (and therefore the notes) would be removed from her estate. However, if she survived the 10-year period, her children would be obligated to make payments until her death. To be able to use the valuation tables under Internal Revenue Code Section 7520 to value the annuity, Virginia obtained a letter from her physician attesting to her health, which provided that she wasn’t terminally ill and that she had at least a 50 percent probability of surviving 18 months or longer. She made sure that she had enough assets to support herself—she had $3 million of assets in her own name, and she was the income beneficiary of eight other trusts holding about $21 million.

Virginia died three years after the annuity agreements were executed, and, in accordance with the agreement, her children hadn’t made any payments to her. Her executor filed an estate tax return, which didn’t include the value of the notes or note partnership interests related to the private annuity transaction. The Internal Revenue Service issued two notices of deficiency, one asserting a gift tax due on the private annuity transaction and one asserting additional estate tax.

The court upheld the deferred private annuity and determined that the transaction wasn’t a gift because the value of the private annuity that Virginia received was full and adequate consideration for the partnership interests she transferred. Due to the letter from Virginia’s physician, it was appropriate to use the Section 7520 tables to value the annuity. The court also found that the children had a real expectation of payment; they had made additional contributions to the partnership themselves; and they had their own assets that would support the payments (until at least Virginia’s life expectancy). Moreover, Virginia, with her business acumen, wouldn’t have entered into the transaction without an expectation that she would receive the annuity payments. 

However, with respect to the QTIP trusts, the court agreed with the IRS that Virginia had disposed of her income interest in the QTIP, which, under IRC Sec-
tion 2519, is treated as a gift of all of the property subject to the income interest (the gift of the income interest itself is treated as a gift under IRC Section 2511). Since the QTIP trusts were terminated in such close proximity to the sale to her children, and there appeared to be no reason for the termination other than to transfer the assets to Virginia for the sale, the court held that the termination and sale should be viewed as one transaction: a sale of her interests in the QTIP trusts. Unlike the QTIP trusts’ prior investments in the partnership interests and notes, Virginia didn’t retain an income interest under the private annuity agreement—no payments were required to be made for 10 years. As a result, Virginia was treated as making a gift of the fair market value of the property held by the QTIP trusts, determined on the date of the private annuity transaction, less the value of her income interest. While it isn’t clear from the court decision, it appears that the value of the gift might be zero because the court had already determined that she had received full and adequate consideration for the value of the QTIP trusts in exchange for the annuity.

IRC Section 2519 doesn’t apply to GPA marital trusts. However, the court addressed whether the termination of the GPA marital trust was a taxable disposition under IRC Section 2514, which provides that an exercise of a GPA is a deemed transfer of the property. Oddly, the court didn’t integrate the annuity transaction into the termination of the GPA marital trust and simply looked at the termination of the GPA marital trust in favor of Virginia’s revocable trust. It held that the transfer to the revocable trust wasn’t a transfer to another person (it was really just a transfer to herself); therefore, it wasn’t a taxable gift. It’s not clear why the court didn’t collapse the termination and annuity transaction to view the transfer from the GPA marital trust as being made to Virginia’s children.

 

• Exchange of life insurance policy by trust doesn’t result in gain—In Private Letter Ruling 201304003 (Jan. 25, 2013), the IRS held that a trust’s exchange of a life insurance policy was covered by IRC Section 1035; therefore, it wasn’t a taxable event. The taxpayer in the ruling was a surviving spouse. The original policy was a survivorship policy on the joint lives of the taxpayer and the deceased spouse held by a trust. The trust transferred the policy to a new trust, which, in turn, exchanged the policy for one on the sole life of the then-surviving spouse.

Section 1035 provides that gain isn’t recognized on an exchange of a contract of life insurance for another contract of life insurance, but only if the policies exchanged relate to the same insured. The IRS explained that because the original policy was solely on the life of the taxpayer, due to the death of the other insured spouse, the insured on the two policies was the same. It concluded there wasn’t a change of the insured person; therefore, the exchange was covered by Section 1035.

 

• IRS Art Advisory Panel reports audit statistics—A recent summary report for The Art Advisory Panel of the IRS (the Panel) provided statistics regarding the valuation adjustments to art made during audit. The Art Appraisal Services (AAS) unit in the Office of Appeals works with the Panel to review and evaluate the value of tangible personal property appraisals submitted by taxpayers in support of their position on income, estate and gift tax returns. AAS appraisers independently review the submitted appraisal of any single work of art valued at $50,000 or more and conduct their own research relevant to the value of the particular item. AAS then submits their research and findings to the Panel. The Panel reviews the research, findings and appraisals to come to a consensus on the value of the property. It then makes a recommendation to the AAS, which, in turn, advises the IRS office reviewing the return.

In 2012, the Panel reviewed 444 items. The Panel recommended accepting 51 percent of the appraisals it reviewed. However, the remaining 49 percent were subject to very large adjustments: The Panel recommended a net 52 percent reduction on appraisals relating to property that was eligible for an income tax charitable deduction and recommended a net 47 percent increase for property that was subject to gift or estate tax.