Tax Law Update 2010-09-01 (1)Tax Law Update 2010-09-01 (1)

Second Circuit vacates Tax Court's determination on inclusion of transferred interest in real estate under IRC Section 2036 — In Estate of Stewart v. Commissioner, No. 07-5370, (2d. Cir. Aug. 9, 2010), the majority of the U.S. Court of Appeals for the Second Circuit agreed with the Tax Court that an implied agreement existed between the decedent, Margot, and her son, Brandon, that triggered inclusion of a portion of a transferred interest in a Manhattan brownstone in Margot's estate under Internal Revenue Code Section 2036. The Second Circuit, however, held that the Tax Court had to make further findings regarding what portion of the transferred interest was includible in Margot's estate.

Margot and Brandon owned a home in East Hampton, N.Y., as joint tenants with rights of survivorship, which they rented in the summer, splitting the rent proceeds. However, for convenience, they arranged it so that only one of their names was on the lease and only one person received the rent. They settled up between themselves periodically so that they split the rent and the expenses. Margot also owned a five-story brownstone in Manhattan. She and Brandon lived on the first two floors and rented the upper three floors to a commercial tenant.

In the fall of 1999, Margot and Brandon met with an estate-planning attorney who suggested that Margot gift a portion of the Manhattan brownstone to Brandon. Margot was diagnosed with pancreatic cancer in December and a few months later in May 2000, she signed a deed transferring a 49 percent tenant-in-common interest in the brownstone to Brandon. She and Brandon continued to live in the first two floors and the commercial lease, which was set to run through July 31, 2002, continued, although rent payments were erratic and not always in full.

Margot died in November 2000 and her estate reported only a 51 percent interest in the brownstone on the estate tax return, which was subject to a discount of 42.5 percent for lack of control and marketability. The Internal Revenue Service issued a notice of deficiency claiming that the value of the entire brownstone (not subject to any valuation discount) was includible in Margot's gross estate under IRC Section 2036 because she had retained possession or enjoyment of the transferred 49 percent interest. The estate filed a petition with the Tax Court, but in 2006, the Tax Court held in the IRS' favor that Margot and Brandon had an implied agreement that she would retain the economic benefits of the 49 percent interest she transferred and, as a result, the full value of the brownstone was includible in her estate under IRC Section 2036.

IRC Section 2036 “includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer…under which he has retained for his life…the possession or enjoyment of, or the right to the income from, the property.” And an express or implied understanding that the decedent would retain possession or enjoyment constitutes a retained interest for the purposes of IRC Section 2036. See Treasury Regulations Section 20.2036-1(c)(1)(i).

The Tax Court found that Margot and Brandon had an implied agreement that she would retain the possession or enjoyment of all of the transferred 49 percent interest because (1) Margot continued to receive the rental payments from the tenant renting the commercial space, and (2) Brandon's testimony that they intended to split the rent and expenses at the end of year wasn't credible. The Second Circuit agreed that Margot had retained possession or enjoyment due to an implied agreement with Brandon of at least some portion of the 49 percent interest in the brownstone. The court noted, however, that Section 2036 isn't “all or nothing” and according to the Treasury regulations, if Margot only retained possession or enjoyment of a part of the 49 percent interest, the amount included in her gross estate is only a corresponding proportion of the 49 percent interest. The Second Circuit held that the Tax Court's failure to assess all of the facts and circumstances regarding the transfer and the subsequent use of the property to determine what part of the 49 percent was included in the gross estate was clear error.

Specifically, the Second Circuit held that Margot and Brandon could only have had an implied agreement with respect to the “commercial portion” of the transferred interest and not the “residential portion.” The opinion noted that Margot and Brandon's cohabitation in the brownstone both before and after the transfer alone didn't indicate an implied agreement and (surprisingly) concluded that “co-occupancy of a residential premises by the related donor and donee is highly probative of the absence of an implied agreement.” The opinion asserts that since Brandon continued to reside in the brownstone, he exclusively enjoyed all the residential portion of the 49 percent interest transferred to him.

The Second Circuit remanded the issue to the Tax Court to determine what income or economic benefit Margot retained from each of the commercial portion and the residential portion of the transferred interest. The Second Circuit held that the portion of the property necessary to generate such retained income should be includible in Margot's estate. It suggested that the Tax Court consider how Margot and Brandon paid the expenses related to the brownstone, as well as how they allocated the income and expenses from the property in East Hampton, since Margot and Brandon had a history of periodically “netting” out the income and expenses and such netting could have encompassed both properties.

A strong dissent from Judge Debra A. Livingston objected to the majority's division of Margot's retained interests into commercial and residential portions and agreed with the Tax Court that, on the whole, the lack of change regarding the use of the property, the retained rent payments and the lack of credible testimony from Brandon all indicated that Margot retained possession or enjoyment of the entire 49 percent interest she transferred to Brandon and that all of such interest should be includible in her estate under IRC Section 2036.

IRS publishes information letter regarding treatment of a grant to an LLC wholly owned by public charity — In Information Letter 2010-0052 (March 15, 2010), the IRS provided guidance regarding a public charity that is the sole member of a limited liability company (LLC). The letter explained that a single-member LLC is generally disregarded for federal tax purposes unless it elects otherwise and, as a result, it would be treated as a component part of the public charity. However, the letter notes that beginning in January 2008, a disregarded entity may be treated as a separate entity for the purpose of certain employment and excise taxes.

The letter explains that the public charity's exempt status will not be jeopardized if the LLC hasn't limited its purposes to charitable purposes in its organizational documents. However, if the LLC lists purposes in its organizational documents that are contrary to the public charity's exempt purposes, the charity's status could be affected. The letter also explains that a private foundation's grant to an LLC that's wholly owned by a public charity will generally be considered to be a qualifying distribution under IRC Section 4942 and not a taxable expenditure requiring expenditure responsibility under IRC Section 4945.

Exercise of power of appointment over GST-exempt grandfathered trust doesn't trigger inclusion under IRC Section 2041(a)(3) — In PLR 201029011 (July 23, 2010), the decedent exercised a power of appointment over a trust, that was grandfathered from the generation skipping transfer (GST) established by her father in his will (prior to Sept. 1, 1985). Upon her death, according to her father's will, the share of the trust for the decedent's benefit was to be paid to her living issue as she appointed in her will; otherwise, the property was to be distributed to her issue per stirpes. The decedent exercised her power of appointment by directing that the trust property be distributed to a different trust (the Family Trust), which ultimately was divided in shares and allocated among trusts for each of her children (the Child's Trust). Each child beneficiary of a Child's Trust was granted a limited power of appointment, exercisable upon his or her death, to appoint the trust property to the issue of the decedent and her husband. This class of permissible appointees was further limited to include only the issue of the decedent living on her death. Under the trust agreement governing the Child's Trusts, each Child's Trust was required to terminate 21 years after the death of the last survivor of the descendants of the decedent's father who were living on the date of the father's death.

Since the decedent's power of appointment wasn't exercisable in favor of herself, her creditors, her estate or its creditors, the decedent didn't have a general power of appointment that would generally cause inclusion in her gross estate under IRC Section 2041(a)(2). However, under IRC Section 2041(a)(3), the value of property subject to a power of appointment may be included in a decedent's gross estate if a decedent exercises the power of appointment by creating another power of appointment that could be validly exercised under applicable local law to postpone the vesting of interests in property for a period that's ascertainable without regard to the date of the creation of the original power.

In this case, the original power of appointment was created on the date of the decedent's father's death. Since the rule against perpetuities period for the property appointed by the decedent was still determined with respect to a period measured from the date of the father's death, and because no exercise of either the decedent's power of appointment or a child's power of appointment could postpone the vesting of a property interest beyond the required period, IRC Section 2041(a)(3) wasn't triggered.

In addition, the appointed property maintained its GST-grandfathered status. Under Treas. Regs. Section 26.2601-1(b)(1), there's no GST tax applicable to transfers under a trust that was irrevocable on Sept. 25, 1985 if (1) the transfer isn't due to the exercise, release or lapse of a general power of appointment, or (2) the transfer isn't pursuant to a limited power of appointment that is exercised in a manner that may postpone the vesting of an interest in the property for a period that extends beyond a period measured by a life in being at the date of the creation of the trust plus 21 years. For the same reasons that IRC Section 2041(a)(3) didn't apply to cause inclusion in the decedent's gross estate (it wasn't a general power of appointment and the limited power of appointment couldn't be exercised to postpone the vesting of property interests beyond a period measured with respect to the date of the father's death), the exercise of the power of appointment didn't affect the property's GST tax-exempt status.

Recipients of settlement payments from estate liable for estate tax deficiency — In a recent Tax Court decision, Upchurch v. Comm'r, T.C. Memo. 2010-169 (Aug. 2, 2010), the IRS prevailed in imposing liability for estate taxes on two beneficiaries who received settlement payments from the executor of the estate. Judith Tasker died on Aug. 20, 2000, leaving a will in which she devised a house located in Winthrop Harbor, Ill., in equal shares to her three children and two children of her deceased husband. However, after she executed her will, she subdivided the land into two parcels and ultimately conveyed one of the parcels to one of her sons and the other parcel to her daughter. As a result, the property wasn't part of her estate and not subject to the will. The two children from her deceased husband's prior marriage, Bruce and Carl, sued the executor of Judith's estate to impose a constructive trust on the property or obtain a declaratory judgment that the quitclaim deeds to her son and daughter were invalid. A few months later, a settlement agreement was signed in which the estate agreed to pay $53,500 each to Bruce and Carl (a total of $107,000).

The estate filed its estate tax return over two years late on May 27, 2003 and distributed all of its assets before receiving a final determination of liability. The IRS audited the return and ultimately disallowed the estate's deduction of the settlement payments as debts of the estate. The executors of the estate signed a Form 890, Waiver of Restrictions on Assessment and Collection of Deficiency and Acceptance of Overassessment, agreeing to the assessment and collection of the taxes. However, the estate never paid. The IRS assessed a $46,758.12 tax deficiency and over $7,000 in interest on July 22, 2005. Two years later, without having received any payment, the IRS sent notices of liability to Bruce and Carl, imposing liability for $46,758.12 on Bruce and Carl as transferees of the estate (it appears that the notice didn't make any mention of the interest). Bruce and Carl petitioned the Tax Court and the IRS assessed an additional “failure to pay penalty” of $11,727.32 against the estate.

IRC Section 6901(a) provides that the IRS may collect on a liability that passes, by law or equity, to a transferee of a decedent. The IRS must prove an independent basis under the applicable state law or equity principles for holding a transferee liable for the estate's debts and that the person is indeed a transferee of the estate.

The Tax Court agreed with the IRS that Bruce and Carl were liable for the tax. Bruce and Carl argued that the other beneficiaries of Judith's estate were the transferors, so that IRC Section 6901, which requires the estate to be the transferor, didn't apply. However, the Tax Court found that the payments pursuant to the settlement agreement were made by the estate and as a result, the estate was the transferor. Bruce and Carl also argued that the payment was an arm's-length negotiation for a waiver of their right to sue to enforce the will and therefore neither of them was a transferee. The definition of “transferee” under IRC Section 6901 is a “donee, heir, legatee, devisee or distributee.” But the court found that since the payment was a substitute for a real property devise, for tax purposes it was appropriate to treat the settlement payment as a devise and Bruce and Carl as devisees. And, since Illinois imposes liability on transferees of an estate to the creditors of the estate as a matter of equity, Bruce and Carl were liable for the additional tax, up to a maximum of the full amount they received (not reduced by the contingency fee paid to the lawyers) of $53,500 each, subject to interest accruing from the date on which the estate's return was due. The Tax Court held that it didn't have jurisdiction to determine the validity of the failure to pay penalty because the IRS hadn't included the penalty on the notice issued to Bruce and Carl.

Tax Court finds executor acted in good faith and holds accuracy penalty doesn't apply — In Robinson v. Comm'r, T.C. Memo. 2010-168 (Aug. 2, 2010), the Tax Court held that James Robinson relied in good faith on his father's estate planner in preparing Form 706 for his father's estate. As a result, the Tax Court found that the accuracy penalty imposed by the IRS didn't apply.