• Tax Court denies Internal Revenue Service motion for summary judgment on net gift discount for IRC Section 2035 liability—In Steinberg v. Commissioner, 141 T.C. No. 8 (Sept. 30, 2013), Jean Steinberg entered into a net gift transaction with her four daughters when she was 89 years old. Her daughters agreed to assume and pay any federal gift tax liability imposed as a result of the gifts. In addition, her daughters agreed to assume any federal or state estate tax liability imposed under Internal Revenue Code Section 2035(b) that would be due if she passed away within three years of the gifts. IRC Section 2035(b) imposes estate tax on the gift tax paid on gifts made within three years of death to tax such deathbed gifts on a “tax inclusive” basis, like the estate tax, rather than the “tax exclusive” basis of gifts made more than three years before death. Section 2035(b) is intended to eliminate the tax incentive from making deathbed gifts. The agreement took several months of negotiation between Jean and her daughters, all of whom were represented by counsel.
Jean retained an appraiser to calculate the fair market value (FMV) of the net gift. The appraiser reduced the value of the gift by the gift tax that the daughters actually paid. He also reduced the value of the gift by the potential Section 2035(b) liability by calculating Jean’s annual mortality rate for the three years after the gift. The amounts at stake were large: The appraiser valued the gift at over $71 million, and the daughters paid gift tax of over $32 million. However, the IRS audited the gift tax return, disallowed the discount that was made for Jean’s daughters’ assumption of the potential liability under Section 2035 and issued a notice of deficiency, increasing the gift tax by about $1.8 million.
Jean filed a petition, and the IRS filed a motion for summary judgment, claiming that the daughters’ assumption of the potential liability under Section 2035(b) didn’t constitute consideration in money or money’s worth in exchange for the gifts; therefore, it shouldn’t affect the value of the gift made.
The value of a gift is the value of the property passing to the donee, reduced by the value of any consideration the donee provides to the donor. Therefore, when a donee agrees to pay the gift tax relating to a gift, which is the liability of the donor, the donee is providing consideration in exchange for the gift. The value of the gift tax reduces the value of the gift (becoming a “net gift”).
The IRS agreed that the assumption of the gift tax liability should reduce the value of the gift. However, it claimed that the daughters’ assumption of the Section 2035 liability wasn’t consideration under the “estate depletion theory.” Under this theory, a donor only receives consideration in money or money’s worth to the extent that the donor’s estate is replenished by the donee’s obligation. The Tax Court held that, as a matter of law, it was possible that the daughters’ promise could replenish the estate. In doing so, it acknowledged that its ruling in McCord v. Comm’r, 120 T.C. 358 (2003), was faulty in that it held that the assumption of liability under Section 2035(b) would accrue to the benefit of the donor’s estate, not the donor; therefore, it couldn’t be consideration for money or money’s worth for the donor. However, this distinction between the donor’s estate and the donor isn’t relevant when considering the estate depletion theory, under which the donor and the donor’s estate are inextricably bound. Depending on the state law regarding apportionment of taxes, the beneficiaries of the estate and other factors, the court held that it would be possible to find that the daughters’ assumption of the portion of the estate tax related to the gift provided a benefit to the estate and, accordingly, to the donor.
In addition, although the IRS hadn’t raised it, the Tax Court went to great lengths to discuss and reverse its holding in McCord regarding the speculative nature of the liability. In McCord, the Tax Court had held that the potential liability of estate tax imposed under Section 2035 was too speculative to be calculated with any certainty; thus, it couldn’t be taken into account when valuing the gift. The U.S. Court of Appeals for the Fifth Circuit, 461 F.3d 614 (5th Cir. 2006), reversed this position. Although not bound by the Court of Appeals in this case, the Tax Court reconsidered its prior position and held that as a matter of law, under the willing buyer/willing seller test, a buyer would insist that the value of the 3-year exposure to additional estate tax be taken into account when valuing the gift and that it wasn’t too speculative to do so. In its reasoning, it analogized to the many decisions that have held that, for gift and estate tax purposes, the FMV of stock received should be discounted by any built-in capital gains tax.
The Tax Court ultimately held that there were genuine issues of material fact as to whether the daughters’ assumption of the liability under Section 2035 was consideration in money or money’s worth; therefore, the IRS wasn’t entitled to summary judgment. Several judges joined in a concurrence, noting that the IRS hadn’t raised the issue of whether the liability was too speculative to be calculated, and the court’s opinion shouldn’t have included this issue. Judge James S. Halpern (who had written the majority opinion for the Tax Court’s decision in McCord) dissented, arguing that allowing a discount for the liability under Section 2035 was contrary to the underlying policy of Section 2035 and Congress’ intent to make deathbed gifts taxable in the same manner as bequests from an estate.