Tax Law Update 2010-11-01 (1)Tax Law Update 2010-11-01 (1)

District court rules on deductibility of various estate administrative expenses under IRC Section 2053 — The U.S. District Court for the Southern District of Texas issued two decisions in Keller v. United States (106 A.F.T.R.2d 2010-6309 (Sept. 14, 2010) and 106 A.F.T.R.2d 2010-6343 (Sept. 15, 2010)) regarding estate tax deductions. The decisions followed up on a prior 2009 decision involving the same estate. In the 2009 decision, the court held that under Texas law, even though Maude O'Connor Williams hadn't formally funded a partnership before her death, her intent to fund the partnership with particular assets was sufficient to cause those assets to be considered partnership property. (See “Tax Law Update,” Trusts & Estates, October 2009, p. 9.) As a result, Maude's taxable estate included partnership interests (subject to valuation discounts), rather than the partnership assets.

The first 2010 decision addressed whether interest owed by the estate to the partnership would be deductible under Internal Revenue Code Section 2053 as a necessary administration expense. IRC Section 2053 provides that:

…the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts

The Treasury regulations provide that an expense must be actually and necessarily incurred in the administration of the decedent's estate to be deductible.

Initially, because the partnership hadn't been formally established at Maude's death, the estate assumed that Maude's revocable trust, known as the “family trust,” owned the assets that Maude had intended to transfer to the partnership. As a result, the trustees of the family trust issued a check to the Treasury for over $147 million to pay the estate tax. However, after Maude's advisors realized that the partnership had been funded, the trustees of the family trust had to borrow the funds from the partnership. The Internal Revenue Service argued that the loan lacked economic substance. But the court disagreed, holding that even though the trustees of the family trust issued the initial check because they assumed there was no liquidity problem for the estate, once it was determined that the partnership existed and had been funded, the need for the loan existed. As a result, the loan was necessary. So, the interest was deductible under IRC Section 2053.

The IRS also argued that some of the interest payments by the family trust and the trusts created under the family trust were made from property “not subject to claims” and therefore were time barred under IRC Section 2053(b). Under IRC Section 2053(b), the deductions under IRC Section 2053(a) “representing expenses incurred in administering property not subject to claims which is included in the gross estate” are allowable only to the extent that “such amounts are paid before the expiration of the period of limitation for assessment provided in IRC Section 6501.” The term “property subject to claims” means property “includible in the gross estate of the decedent which, or the avails of which, would under the applicable law, bear the burden of the payment of such deductions in the final adjustment and settlement of the estate…”

However, the court again disagreed and held for the taxpayer that since the property held in the family trust and its subtrusts was includible in Maude's gross estate and would bear the burden of paying such expenses under Texas law, the interest payments were made from property “subject to claims” and weren't time barred.

In its second 2010 decision, the court ruled on the amount of interest that was deductible and whether other administrative expenses, such as accounting and legal fees, executor and trustee fees and maintenance expenses were deductible. The court's more interesting rulings included:

Overall, the court allowed administrative expense deductions totaling $60,357,085.39.

District court denies deduction for estate's projected state income tax liability as claim against estate — In another case dealing with deductions under IRC Section 2053, the U.S. District Court for the Northern District of California held for the IRS, ruling that the estate of Marshall Naify couldn't deduct the estate's estimate of the decedent's income tax liability to California (Marshall Naify Revocable Trust v. U.S., 106 A.F.T.R.2d 2010-6236 (Sept. 8, 2010)).

In 1998, Marshall formed Mimosa, a wholly-owned Delaware investment corporation and contributed notes which were convertible into stock of Telecommunications, Inc. (TCI). Later, Mimosa exercised the conversion right and the notes were converted into TCI stock. Marshall had organized Mimosa so that it wouldn't be a California corporation (its offices were in Reno, Nev.) to take the position that the conversion wasn't taxable by California.

After Marshall's death in 2000, the estate filed Marshall's final income tax return and claimed that no California income tax was due on the gain attributable to the conversion. However, the estate tax return listed $62 million as a deductible claim against the estate, which was the estate's estimate of the California income tax due. Ultimately, California audited the estate, which settled the income tax liability with a payment of $26 million. Accordingly, the IRS allowed a deduction of $26 million as the claim against the estate. The estate sued for a refund based on a deduction of $47 million, which was an adjusted estimate of what its California income tax liability was as of the date of death: the $62 million discounted by the possibility that the tax plan would be successful and avoid California income tax altogether.

IRC Section 2053 provides that the value of the taxable estate is determined by deducting amounts including claims against the estate. Treas. Regs. Section 20.2503-1(d)(4) allows a deduction that meets the other requirements of IRC Section 2053 even though it's not yet paid, “provided that the amount to be paid is ascertainable with reasonable certainty and will be paid.” But, it prohibits deductions for “a vague or uncertain estimate.”

The court agreed with the IRS and held that the estimate of $47 million wasn't deductible. The court held that the likelihood of the audit, the outcome of the audit and the potential for settlement were contingencies that rendered the liability uncertain and unascertainable. Furthermore, it wasn't clear that the liability ultimately would be paid — the court wasn't convinced that the $47 million estimate, which represented a discounted $62 million liability, was an amount the estate actually expected to pay. The court interpreted Ninth Circuit precedent as allowing it to consider post-death events and held that the ultimate payment of $26 million should be the deductible amount. Lastly, the court held that the estate was estopped from taking the position on its income tax return that there was no California income tax liability while simultaneously taking the opposite position on its estate tax return.

Analogizing to Holman v. Commissioner, a district court agrees with the IRS that LLC restrictions should be disregarded for valuation purposes under IRC Section 2703 — In a recent decision (Fisher v. U.S., No. 1:08-CV-0908-LJM-TAB (Sept. 1, 2010)) regarding a motion for partial summary judgment, the U.S. District Court for the Southern District of Indiana held against the taxpayer that the restrictions on transfers in a family limited partnership (FLP) agreement shouldn't be taken into account when valuing the interests for gift tax purposes. In a previous decision, the court had rejected the Fishers' argument that the gifts of interests in the FLP should qualify for the annual exclusion. (See “Tax Law Update,” Trusts & Estates, May, 2010, p. 10.)

In 2000, 2001 and 2002, the Fishers transferred a 4.762 percent interest in Good Harbor Partners LLC (the LLC) to each of their seven children. The LLC owned undeveloped land on Lake Michigan. Under the operating agreement, a child could transfer his interest with notice to the LLC. But, if the proposed transfer was to a non-family member, the LLC would have the right to purchase the interest at the offer price within 30 days of the notice.

IRC Section 2703 provides that the value of property shall be determined without regard to any option, agreement or other right to acquire or use the property at a price less than the fair market value unless the option, agreement or right (1) is a bona fide business arrangement, (2) is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration, and (3) has terms that are comparable to similar arm's length transactions.

The court analogized to the case of Holman v. Comm'r (105 A.F.T.R.2d 2010-1802 (8th Cir. 2010)) and held that there was no business purpose to the LLC. In Holman, the taxpayers funded a partnership with publicly traded stock and then gave partnership interests to trusts for their children. The Eighth Circuit affirmed the Tax Court's holding that the partnership restrictions on transfers should be disregarded in valuing the partnership interests for gift tax purposes under IRC Section 2703. The court reasoned that there was no business purpose to the partnership, which held only passive investments without any planned investment strategy. As in Holman, the court in Fisher acknowledged that maintenance of family ownership and control of a business may be a bona fide business purpose. However, the court found no evidence of a business purpose to the LLC's retention of the undeveloped land. The court noted that (1) the family never made any investment in the property to increase its value, (2) there was no intent to sell the property, and (3) there was no indication that the family members were looking to acquire additional real property as an LLC investment. As a result, the court held that the Fishers hadn't raised an issue of material fact with regard to whether the LLC was a bona fide business.

On the heels of Holman, Fisher indicates not only that the restriction in question must foster active involvement in the business, but also that the activities and administration of an FLP must show that the partnership is actively engaged in a business operation in order for the restriction to avoid being disregarded under IRC Section 2703. Contrast this to the bona fide sale exception in IRC Section 2036, which only requires a non-tax purpose, based on case law.