• IRS publishes inflation-adjusted items for 2014—In Revenue Procedure 2013-35,1 the Internal Revenue Service set forth inflation-adjusted tax items for 2014. These inflation adjustments, which take effect on Jan. 1, 2014, include the following:
• For decedents dying in 2014, the basic exclusion amount for determining the amount of the unified credit against estate tax under Internal Revenue Code Section 2010 will be $5.34 million (up from $5.25 million). Accordingly, the basic exclusion amount for determining the amount of the unified credit against gift tax under IRC Section 2505 and the generation-skipping transfer tax exemption amount under IRC Section 2631 will both, likewise, be $5.34 million in 2014.
• The gift tax annual exclusion amount under IRC Section 2503 will remain at $14,000 in 2014; however, the amount of qualifying gifts to a non-citizen spouse that won’t be included in the year’s taxable gifts under IRC Sections 2503 and 2523(i)(2) will increase to $145,000 in 2014 (up from $143,000).
• For an estate of a decedent dying in 2014, if the executor elects to use the special use valuation method for qualified real property under IRC Section 2032A, the resulting aggregate decrease in the property’s value for estate tax purposes can’t exceed $1.09 million (up from $1.07 million).
• Estate’s special use valuation establishes beneficiaries’ basis in ranchland—In Van Alen v. Commissioner,2 the Tax Court held that two beneficiaries of an estate were estopped from claiming that their basis in an interest in land that they inherited was greater than the Section 2032A special use valuation of the interest that had been reported on the estate tax return.
When their father died in 1994, siblings Shana Tomlinson and Brett Van Alen became the sole beneficiaries of a testamentary trust that received the residue of their father’s estate, which included a substantial interest in a ranch in California. The fair market value (FMV) of the ranch interest that was determined by the deputy probate referee for the estate was $1.963 million, but the executor (Shana’s and Brett’s stepmother) elected to use the special use valuation method under Section 2032A to value the ranch interest for estate tax purposes. As a result, the value of the land for estate tax purposes was $98,735. As required by Section 2032A, Shana and Brett (a minor who was represented by his mother as his guardian ad litem) executed an agreement attached to the estate tax return, consenting to the special use valuation election.
In May 2007, the trust sold a conservation easement on the ranch for $910,000. Although the trust’s initial 2007 income tax return reflected a gain from the sale to each of Shana and Brett of nearly $360,000, and an amended return reflected a gain to each of them of about $310,000, neither Shana nor Brett reported the gain on their respective 2007 individual income tax returns. After receiving a resulting notice of deficiency from the IRS, Brett consulted a local certified public accountant. Upon learning of the $1.963 million FMV of the ranch interest for the estate, the CPA filed another amended 2007 income tax return for the trust. This amended return reported a basis in the ranch of just under $900,000 (without explanation), resulting in no gain for Shana or Brett from the sale. The IRS maintained its notice of deficiency, arguing that the special use valuation of the ranch interest, as reported on the estate tax return (even if absurdly low), was the value that the trust (and by extension, Shana and Brett) had to use as their basis in the ranch interest. Shana and Brett petitioned the Tax Court, and their cases were consolidated.
IRC Section 1014(a)(3) provides that, in the case of a special use valuation election under Section 2032A, the basis of property acquired or passing from a decedent shall be its value determined under Section 2032A. Shana and Brett, however, relied on Revenue Ruling 54-97, 1954-1 C.B. 113 to argue that they could report a basis for the ranch interest different from its special use value for income tax purposes. That ruling says (in relevant part) that:
. . . for the purpose of determining the basis under section 113(a)(5) of the Internal Revenue Code of property transmitted at death (for determining gain or loss on the sale thereof . . .), the value of the property as determined for the purpose of the Federal estate tax shall be deemed to be its fair market value at the time of acquisition. Except where the taxpayer is estopped by his previous actions or statements, such value is not conclusive but is a presumptive value which may be rebutted by clear and convincing evidence.
The Tax Court pointed out that it might have been reasonable for Shana and Brett to rely on this ruling to offer up such “clear and convincing evidence” if they were calculating their basis in the ranch interest under Section 1014(a)(1) (the successor IRC provision to the “section 113(a)(5)” cited in the ruling), but that the IRC section at issue in this case was Section 1014(a)(3). However, the Tax Court went on to say that it didn’t need to resolve the issue of the ruling’s applicability to the case at hand because the case could be determined by applying the doctrine of the duty of consistency. Quoting LeFever v. Comm’r,3 the Tax Court noted that the duty of consistency:
. . . is based on the theory that the taxpayer owes the Commissioner the duty to be consistent with his tax treatment of items and will not be permitted to benefit from his own prior error or omission.
The Tax Court stated that three conditions must be satisfied to apply the duty of consistency: (1) a representation or report by the taxpayer; (2) reliance by the Commissioner; and (3) an attempt by the taxpayer after the statute of limitations has run to change the previous representation or recharacterize the situation in such a way as to harm the Commissioner. The Tax Court noted that the primary dispute in this case was in regard to the first condition. Shana and Brett argued that they couldn’t have made the requisite representation or report regarding the special use valuation of the ranch interest because they were merely beneficiaries of their father’s estate, and as such, neither of them had fiduciary powers or control over the estate. However, because Shana and Brett (through his guardian ad litem) had executed the agreement in which they had consented to the special use valuation election, the Tax Court reasoned that they were distinguishable from beneficiaries who had no involvement with the estate tax return. The Tax Court concluded that this fact, combined with their shared economic interests with their father’s estate (by virtue of their status as residuary beneficiaries), bound them to the special use valuation reported on the estate tax return. Moreover, the Tax Court found that the Commissioner relied on the special use valuation and that only after the statute of limitations ran with respect to the estate tax return did Shana and Brett argue that the special use valuation was too low. Accordingly, the Tax Court held that the duty of consistency estopped Shana and Brett from claiming that their basis in the ranch interest was other than the Section 2032A special use valuation reported on the estate tax return.
Finally, the Tax Court held that Shana and Brett were subject to accuracy-related penalties as a result of their failure to report their respective shares of the capital gains tax. Although Shana and Brett claimed that they reasonably relied on their CPA’s advice, the Tax Court noted that Shana and Brett didn’t consult their CPA until well after they filed their 2007 income tax returns.
• Remainder interest in QTIP can’t avoid tax—In Estate of Virginia Kite v. Comm’r,4 the Tax Court addressed the tax consequences of a series of transactions involving marital trusts for the benefit of Virginia Kite. Virginia was the income beneficiary of two qualified terminable interest property (QTIP) marital trusts that owned a combined 24.87 percent interest in a family general partnership. The QTIP trusts were terminated and the partnership interest distributed to Virginia’s revocable trust, which immediately sold the interest to Virginia’s children in exchange for three unsecured annuity agreements. The agreement required Virginia’s children to pay her an annual sum for her lifetime, beginning 10 years after the sale. Virginia died in 2004, before the first annuity payment was due.
The court determined that the deferred private annuity transaction wasn’t a gift under IRC Section 2501 because the value of the private annuity that Virginia received was full and adequate consideration for the partnership interests she transferred. However, the court viewed the termination of the QTIP trusts and immediate sale by the revocable trust as a single transaction and held there was a disposition of Virginia’s income interest in the QTIP trusts, which, under IRC Section 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). However, the court didn’t explain how the consideration figured in.
In a subsequent unpublished opinion, the Tax Court entered a judgment on Oct. 25, 2013 against Virginia’s estate for a gift tax deficiency of $816,206 for the gift of the remainder interest. The court stated that the previous finding that Virginia received full and adequate consideration in the annuity transaction didn’t mean that she received full and adequate consideration for the qualified income interest and remainder interest. It held that the remainder interest is a future interest held by the remaindermen and not Virginia; therefore, Virginia couldn’t receive consideration for it. The court also discussed that eliminating the gift tax on the remainder interest would circumvent the estate tax, which was an argument the IRS raised in the prior case before the Tax Court.
The IRS and the Tax Court clearly didn’t like this transaction because, although Virginia was supposedly paid for the interest sold, the annuity payments were deferred 10 years, and she died before the first payment. Therefore, all of the property in the marital trusts could have avoided estate tax. However, the holding isn’t so limited. The IRS could use this case to attack any transaction in which a marital trust is terminated, and shortly thereafter, the spouse-beneficiary sells the assets to a third party. For example, say a marital trust is terminated and stock is distributed to Jane, the beneficiary. Jane immediately sells the stock to her children for $1 million cash. If the IRS were to apply the step-transaction doctrine and Kite, the IRS could claim that Jane sold the income interest for $1 million and made a gift of the remainder interest under Section 2519, because the remainder interest was not hers to sell. But in this example, there’s no circumvention of the gift or estate tax.
1. Revenue Procedure 2013-35, I.R.B. 2013-47 (Oct. 31, 2013).
2. Van Alen v. Commissioner, T.C.M. 2013-235 (Oct. 21, 2013).
3. LeFever v. Comm’r, 103 T.C. 525 (1994), aff’d, 100 F.3d 778 (10th Cir. 1996).
4. Estate of Virginia Kite v. Comm’r, 4 T.C. Memo. 2013-43 (Feb. 7, 2013).