• Tax Court addresses real estate valuation issues—In Estate of Giovacchini, T.C. Memo. 2013-27 (Jan. 24, 2013), the Tax Court addressed a dispute regarding the valuation of a unique property in the Lake Tahoe, Calif. basin. Shirley Giovacchini, the descendant of Nevada pioneer families, acquired a parcel of nearly 2,500 acres of mountainous terrain near Heavenly Valley Ski Resort called “High Meadows.” In 1999, two years after her husband died, Shirley transferred the property to a trust, of which she and her daughter were trustees. A year later, in 2000, the trust sold 50 percent of the property to a limited liability company (LLC) owned by Shirley and her three daughters for $2.5 million. The family used the value of the property determined for the estate tax return of Shirley’s husband (the 1997 appraisal), adjusted for an annual increase based on the Consumer Price Index, as the sale price. Shirley reported several unrelated taxable gifts on her gift tax return for the year, but didn’t report the sale of the property to the LLC because her accountant advised her that the sale was for fair market value and wasn’t a gift.
Meanwhile, members of the American Land Conservancy (ALC) had contacted Shirley and her daughters to discuss acquiring the property for conservation purposes. Eventually, in October 2001, four days before Shirley’s death, the parties entered into a purchase agreement in which the trust and the LLC agreed to sell 1,730 acres of the property to ALC, which would simultaneously transfer the property to a public agency. ALC wasn’t acquiring the property on its own behalf, but was instead trying to orchestrate the sale to a public agency to preserve the property for open space and recreation. The purchase and sale agreement contemplated that ALC would simultaneously close its acquisition of the property and its own conveyance to a public agency. The closing date wasn’t certain, but if the transaction didn’t close within one year of the purchase and sale, ALC would surrender its initial deposit payment and would be required to make additional escrow payments.
Shirley’s estate tax return reported the value of her 50 percent interest in the property at approximately $3.2 million. This was determined by updating the original 1997 appraisal produced for her husband’s estate ($8 million), multiplying that value by 50 percent to reflect her interest ($4 million), applying a 30 percent fractional interest discount ($2.8 million) and adding the value of the timber ($400,000). At the end of 2001, after signing the purchase and sale agreement, ALC began the process of trying to coordinate the sale of the property to a U.S. agency. It hired an appraiser to determine the value of the property, who appraised it at $25 million. ALC continued to look for a purchaser for the property and pursued the U.S. Forest Service (USFS). For the USFS to proceed with a potential purchase, it needed to have the property re-appraised according to its internal standards, and it commissioned another appraisal by the same individual at the end of 2002. The 2002 appraisal valued the property at $29.5 million.
In January 2003, after several amendments to the original purchase and sale agreement among ALC, the trust and the LLC, which extended the closing date and initial escrow payments, ALC and the U.S. Department of Agriculture entered into a written contract for the sale of ALC’s interest in High Meadows for $29.5 million.
The Internal Revenue Service issued two separate notices of deficiency in 2005: one for a gift tax deficiency of over $3.7 million regarding Shirley’s 2000 gift tax return and the other for an estate tax deficiency of almost $10 million, along with valuation penalties. The IRS valued the 50 percent interest included in the estate at $16.059 million, an increase of nearly $13 million compared to what the estate reported.
The court went through a lengthy analysis of the property and the various appraisal reports provided by experts. It noted how unique the property was in both size and location. It ultimately determined that the estate’s appraisal undervalued the property and that the appraisals obtained by ALC and the USFS for the purchase and sale overvalued the property because they didn’t consider the restricted access and constraints on development for the parcel. The court stated that it wasn’t bound to accept the value of the property paid by the U.S. agency and, instead, determined its own value of the property for both gift tax and estate tax purposes (total value of the property being $21.3 million as of the date of death and $18.5 million as of the date of the gift). In addition, it held that valuation penalties weren’t appropriate, because the estate demonstrated good faith reliance on the advice of the family’s accountant and the original appraiser, who were well-informed, competent professionals. The IRS argued that the family was on notice that the property was worth significantly more because of the appraisals performed for the purchase and sale. However, the court found that the family’s reliance on the professionals was reasonable and in good faith.
This case is a good reminder that it might be useful to disclose non-gift transactions on a gift tax return to start the statute of limitations.
• Tax Court upholds state court determinations that gifts were irrevocable—In Estate of Sommers v. Commissioner, T.C. Memo. 2013-8 (Jan. 10, 2013), the Tax Court addressed whether state court decisions regarding a decedent’s lifetime transfers bound the estate. Sheldon Sommers, a successful physician, had acquired a valuable art collection. After the death of his first wife, he married Bernice. Within a short time, he and Bernice divorced, and he moved to Indiana. While there, he consulted an estate-planning attorney to help him make gifts of the artwork to his nieces. In fact, before he had even spoken to the attorney, he had arranged for the art to be moved to his nieces’ homes. Sheldon didn’t want to pay any gift tax, but the value of the art exceeded his lifetime gift tax exemption. Sheldon and his attorney decided to transfer the art to an LLC and make gifts of LLC units to his nieces over multiple years and keep the value of the gifts within his gift tax exemption and annual exclusions. In late December 2001, Sheldon established an LLC and funded it with the artwork. He owned 99 percent of the voting units and 98 percent of the non-voting units. His nieces received the remaining units (1 percent voting and 2 percent non-voting) in exchange for cash they contributed. Then, Sheldon and his nieces executed three documents, which provided for the transfer of voting and non-voting units to the nieces. The documents left the total number of units transferred and the units transferred to each niece, blank. In early January 2002, nearly identical documents were executed. The parties’ goal was for Sheldon to make gifts that would transfer all of the LLC units in a manner that would keep the gift within his gift tax exemption.
In April 2002, after the documents were signed, an appraiser valued the LLC interests and determined the number of units transferred. His appraisal determined a higher value for the artwork and the units than Sheldon and his nieces expected. Around the time the appraisal was completed, the nieces learned that Sheldon planned to remarry Bernice and move back to New Jersey. Based on the valuation, the nieces understood that if Sheldon passed away, his remaining interest in the LLC would pass to Bernice. They weren’t interested in being members of the LLC with Bernice. The parties agreed that Sheldon would increase his 2002 gift to be the entire balance of the LLC and that the nieces would pay the gift taxes resulting from the larger gift.
The attorneys filled in the number of units transferred on the documents for the 2001 and 2002 gifts. In addition, they revised the 2001 gift documents to include a recital stating that Sheldon desired to transfer to each niece a number of units equal to $233,417, as determined by appraisal, with such value being one-third of his lifetime gift exemption, plus an annual exclusion. The attorneys revised the 2002 documents to reflect the nieces’ agreement to pay the gift tax.
However, shortly afterwards, in the summer of 2002, Sheldon decided that he wanted to revoke the gift, and he sued his nieces in Indiana court, claiming that the gift was revocable because the number of units was left blank in the original signed documents. Sheldon died before the case was resolved. However, the Indiana court ultimately held that the gifts of all of his LLC units in 2001 and 2002 were irrevocable, even if the exact number of units wasn’t included on the documents.
While the Indiana case was pending, Sheldon’s estate filed a suit in New Jersey court alleging that the gifts were incomplete and revocable and seeking apportionment of New Jersey estate tax from the nieces. The New Jersey court disagreed and found that the gifts to the nieces were irrevocable.
Even though the estate had initially filed gift tax returns reporting the transfers to Sheldon’s nieces as taxable gifts, the estate tax return included the value of the artwork in Sheldon’s gross estate and took the position that the prior gifts were revocable, and therefore, no completed gifts were made for federal gift tax purposes. This reduced the estate by reducing the amount of gift tax includible in the estate under Internal Revenue Code Section 2035. And, because it had included the LLC interests/artwork in the gross estate, the estate argued that New Jersey law apportioned the estate tax attributable to the LLC interests to the nieces, which, in turn, increased the property that could pass to Bernice and be eligible for the marital deduction, reducing the tax. However, the IRS disagreed. It issued two notices of deficiency, one claiming that the gift tax returns undervalued the gifts and the other asserting an increased value of the estate due to the increased gift tax includible under Section 2035 and the increased value of taxable gifts that are added to the estate before applying the decedent’s unified credit.
The parties both filed for summary judgment on the issue of whether the state court determinations bound the estate. The court held that the state court proceedings all involved the same issue of whether the transfers were complete and irrevocable and that the estate was collaterally estopped from arguing that the transfers weren’t gifts for federal gift tax purposes or that Sheldon retained a power to alter, amend, revoke or terminate the transfers. The court also explained that the blanks in the documents didn’t mean a completed gift couldn’t occur. It interpreted the documents as part of an overall agreement among the parties to transfer LLC units in a manner that would avoid federal gift tax. The parties didn’t know how many units would be transferred because the valuation hadn’t yet occurred. The blanks, in the court’s opinion, weren’t evidence of revocability, but simply part of the plan to have the appraisal determine the number of units transferred. Therefore, the parties’ intent to make a gift based on a total fixed amount didn’t render the gift incomplete; interestingly, the court seems to have read the blanks to infer a Wandry-type formula.
While the court didn’t find the blanks in the document to be problematic, Sheldon and his estate would have had even less of an argument to make had the documents used a formula based on Sheldon’s gift tax exemption and his LLC units, rather than leaving the number of units to be filled in later.
•Adjustment of IRC Section 6166 deferral of estate taxes due to audit—In Chief Counsel Advice 201304006 (Jan. 25, 2013), the taxpayer made an election under Section 6166 to defer the payment of estate taxes. After its estate tax was re-determined by audit, the estate requested a ruling regarding whether it could expand the Section 6166 election to the estate’s entire interest in the business. The adjustment of estate taxes wasn’t related to the business interest.
The CCA didn’t allow the estate to expand its election because the audit increased the estate tax relating only to non-business property. It explained that under the regulations, if a deficiency is assessed relating to a business interest, then the portion of the deficiency relating to the business may be pro-rated and the Section 6166 installment payments adjusted accordingly. However, if the deficiency isn’t related to the business, then no deferral of the deficiency is allowed. By asking to expand the election, the estate was attempting to defer the payment of the deficiency not related to the business, which wasn’t permitted.
• Tax Court denies income tax charitable deduction for allowing local fire department to use home for training services—In Patel v. Comm’r, 138 T.C. No. 23 (June 27, 2012), the Tax Court denied an income tax deduction for taxpayers’ donation of their home for the local fire department to use in training exercises. The Patels purchased a residence in Vienna, Va. in May 2006, intending to demolish it and build a new house on the lot. They learned of a program run by the Fairfax County Fire and Rescue Department (FCFRD), through which a property owner could allow the FCFRD to use an owner’s property for live fire training exercises, which included demolishing the property. The Patels were interested in the program, so they applied for a demolition permit for the property and completed the necessary waivers and paperwork. The permit and application was approved, and the FCFRD performed its live training exercises in October 2006. The Patels completed the demolition and proceeded to build their new home. On their 2006 federal income return, they claimed a non-cash charitable contribution of $339,504, consisting of the value of the home.
The IRS sent the Patels a notice of deficiency denying the charitable deduction and including accuracy-related penalties. The Tax Court agreed with the IRS, relying on IRC Section 170(f)(3), which denies a deduction for donations of partial interests in property. That section prohibits a deduction for a grant of anything less than the taxpayer’s entire interest in the property and notes that a contribution by a taxpayer of the “right to use property shall be treated as a contribution of less than the taxpayer’s entire interest in such property.” The taxpayers argued that their donation granted FCFRD the right to destroy the house, and therefore, they had donated all of their rights, title and interest to the house. However, the Tax Court disagreed, holding that since the taxpayer retained title to the home and the land, the grant to the FCFRD was a grant of a partial interest. There are several exceptions for certain types of partial interests that are eligible for the charitable deduction, most notably the “undivided portion” exception. This exception allows a charitable deduction for a partial interest if it’s an undivided portion of a donor’s entire interest in the property, for example, “a fraction or percentage of each and every substantial interest or right owned by the donor.” However, the Tax Court reasoned that allowing the FCFRD to use the home for training exercises and, as a result, destroy the home, was a license to use the property, not a transfer of a property interest that qualified as an undivided portion of the Patels’ ownership rights to the property. Therefore, the charitable deduction wasn’t allowable.