• Second Circuit strikes down DOMA as unconstitutional—In Windsor v. United States, 110 A.F.T.R.2d 2012-xxxx (Oct. 18, 2012), the U.S. Court of Appeals for the Second Circuit held for the taxpayer and affirmed the district court’s holding that Section 3 of the Defense of Marriage Act (DOMA) was unconstitutional. Edie Windsor and her spouse, Thea, were residents of New York. They registered as domestic partners in New York and, after Thea’s health deteriorated due to multiple sclerosis and a heart condition, they married in Canada. Thea died in February 2009. Her estate passed to Edie, but because Section 3 of DOMA requires that the word “marriage” mean only a legal union between one man and one woman, the property passing to Edie didn’t qualify for the estate tax marital deduction under Internal Revenue Code Section 2056. As a result, the estate paid $363,053 in estate tax. In 2010, Edie commenced a suit seeking a refund of the federal estate tax.
The district court applied rational basis review, which only requires that the legislation bear a rational relationship to a legitimate governmental objective. While the court didn’t explicitly state that it was applying a more “searching” form of rational basis scrutiny, it found that DOMA didn’t bear a rational relationship to legitimate government interests. On appeal, the majority of the Second Circuit found that homosexuals were a quasi-suspect class: (1) that historically has endured persecution and discrimination, (2) whose class characteristic bears no relation to aptitude or ability to contribute to society, (3) that’s a discernible group with non-obvious distinguishing characteristics, and (4) that’s a politically weakened minority. The court then held that a heightened form of scrutiny was justified and, therefore, applied intermediate scrutiny, rather than rational basis review. To withstand intermediate scrutiny, a classification must be “substantially related” to an “important” government interest, and the justification for the legislation must be actual and genuine. The Second Circuit held that Section 3 of DOMA doesn’t withstand intermediate scrutiny, because it doesn’t: (1) promote uniformity, due to the discord it creates with the various state statutes defining marriage; (2) save government resources in a permissible fashion; or (3) preserve traditional marriage, because the states are still left to determine who may marry.
One of the three judges dissented, arguing that rational basis review applied. In his dissent, he argued that DOMA withstood rational basis review, because it promoted responsible procreation and childrearing and ensured that federal benefits are accessed uniformly, regardless of state determinations on marriage. He concluded that this issue, which is the subject of significant debate, should be resolved by elected representatives, rather than the courts.
• Government withdraws appeal of Wandry—The government withdrew its appeal of the Wandry ruling, decided earlier this year (T.C. Memo. 2012-88), in which the Tax Court approved a defined valuation clause. The opinion approved the taxpayer’s use of a defined valuation clause in transferring limited liability company (LLC) units to avoid paying additional gift tax after the value of the transferred property was increased following an Internal Revenue Service audit.
The taxpayers in the case had funded an LLC and made several transfers of LLC interests to their children and grandchildren. The transfer documents required the taxpayers to transfer that number of LLC units for which the fair market value (FMV) for federal gift tax purposes was equal to a certain dollar value. The documents recited that, although the number of units gifted was fixed on the date of the gift, that number of units was based on the FMV of the gifted units, which couldn’t be known until the FMV of the units was determined by an appraiser as of the date of the gift. If the appraiser’s determination was revised by the IRS or a court through the audit process, the number of gifted units would be adjusted accordingly, so that the number of gifted units met the dollar value intended.
The Tax Court memorandum decision was the first case to approve defined valuation clauses that protect taxpayers from paying additional gift tax in the event of revaluation, without a charitable residuary beneficiary. As a memorandum opinion, its precedential value is considerably less. Unfortunately, now that the government has withdrawn its appeal and declared that it won’t acquiesce to the decision, it looks like practitioners may have to wait for another case to move up to the circuit level before having further assurance.
• Ruling denies retroactive effect of state court reformation—In Private Letter Ruling 201243001 (released Oct. 26, 2012), the IRS denied the retroactive effect of a proposed state court reformation.
The taxpayer in the PLR wanted to disclaim an interest in a trust established by his parent. While his parent was still alive, the parent and son met with the parent’s attorney to amend the parent’s revocable trust. The amendment provided that on the death of the parent, a certain percentage of the trust would pass outright “to [Son], if surviving, but he shall have the right to disclaim all or any part of his share of said assets.” If the son disclaimed all or any part of his share of the trust, the disclaimed property was directed to pass to a separate irrevocable trust, of which the son and his surviving lineal descendants were beneficiaries. The son was the trustee of this irrevocable trust and, as trustee, could make distributions to or for the benefit of the beneficiaries for their health, education, maintenance and support in reasonable comfort. On the son’s death, the irrevocable trust would terminate, and the trust would be distributed to the son’s lineal descendants.
After the parent died, the attorney who prepared the amendment became aware that the son could disclaim the property from the parent’s revocable trust without the disclaimer being treated as a gift. Since the disclaimed property would be transferred to a trust for the benefit of the son, the disclaimer wouldn’t be a qualified disclaimer under Internal Revenue Code Section 2518. The son petitioned the local court to reform the trust to remove the outright distribution and disclaimer provision and, instead, provide that the certain percentage of trust property would pass directly to the irrevocable trust. The son hoped to allocate the parent’s generation-skipping transfer tax exemption to the property, so that it wouldn’t be taxable in the son’s estate at his death. The court issued an order reforming the trust, which was contingent upon a favorable ruling from the IRS.
In the PLR request, the son argued that the amendment created an ambiguity or a scrivener’s error due to a mistake of law or fact and that the reformation should be recognized retroactively for federal tax purposes. The IRS disagreed. It noted that the petition to the local court asserted that the attorney made a drafting error or mistake and that the reformation was intended to carry out the parent’s intent. The local court didn’t conclude that there were any ambiguities in the parent’s revocable trust or the amendment, and there wasn’t sufficient evidence indicating that the parent intended the son’s share of the revocable trust property to be distributed to the irrevocable trust. Therefore, the IRS refused to give retroactive effect to the reformation for federal estate tax purposes.