Tax Law Update 2010-03-01 (1)Tax Law Update 2010-03-01 (1)

Hackl upheld: Gifts of interests in closely held companies do not qualify for annual exclusion — In Price v. Commissioner, TC Memo 2010-2, the Tax Court refused to reconsider its holding in Hackl v. Comm'r, 118. T.C. 279 (2002) and held that the taxpayers' gifts of partnership interests did not qualify for the annual exclusion due to the restrictions in the partnership agreement.

Walter M. and Sandra K. Price formed Price Investments Limited Partnership to facilitate the sale of their diesel power equipment company. After the Prices funded the partnership with company stock and real estate owned by the company (Walter's and Sandra's revocable trusts were each 49.5 percent limited partners and owned Price Management Corporation, the 1 percent general partner), the partnership sold the stock and invested the sale proceeds in marketable securities. The partnership kept the real estate. The Prices gave limited partnership interests to their children each year from 1997 through 2002 and claimed the gift tax annual exclusion for the gifts.

The Internal Revenue Service disallowed the annual exclusions and issued notices of deficiency on the grounds that the gifts were of future interests and therefore did not qualify for the annual exclusion. The Prices appealed.

Under Internal Revenue Code Section 2503(b), the gift tax annual exclusion applies only to gifts of present interests. Treasury Regulations Section 25.2503-3(a) defines a present interest as an unrestricted right to the immediate use, possession or enjoyment of either the property or its income. The U.S. Supreme Court has held that the donee must derive a substantial present economic benefit, and that the real question is not when an interest vests but when the donee can enjoy the interest. See Fondren v. Comm'r, 324 U.S. 18 (1945). Contingencies that stand in the way of the donee enjoying the property may cause the gift to be of a future interest.

The Tax Court first addressed whether the children had an unrestricted right to the use and enjoyment of the limited partnership interests and, by analogy to Hackl, found that the children had no right to a substantial present economic interest with regard to the property. In Hackl, limited liability company (LLC) members could not withdraw capital contributions and could only withdraw from the LLC with the consent of the manager. The partnership agreement in Price likewise prohibited withdrawals of capital contributions and did not allow withdrawal from the partnership. As in Hackl, where the LLC manager had to approve all transfers of partnership interests, the partnership agreement in Price prohibited transfers unless all of the partners consented to the transfer or the transfer was from a limited partner to other (existing) partners. The court noted that obtaining the approval of other partners is a contingency that prevents the children from enjoying a present economic benefit.

In addition, in the event of any voluntary or involuntary transfer, the partnership and each of the partners had a right of first refusal to purchase the interest for fair market value. There was no deadline by which the other partners had to exercise their right of refusal over a voluntary transfer. This ongoing right of first refusal was a further contingency that stood between the children and their ability to obtain value for their interests.

The Tax Court next addressed whether the children had an unrestricted right to use and enjoy the income from the limited partnership interests. Under Hackl, a donee has the unrestricted right to use and enjoy the income if the partnership generates income at or near the time of the gifts and an ascertainable portion of the income flows steadily to the donees. The partnership owned rental property that generated income, but profits were distributed at the discretion of the general partner, and no distributions of income were made in two of the years in which gifts were made. The partnership agreement further provided that distributions were secondary to the partnership's primary purpose of achieving long-term returns and that no distributions of income to cover the partners' income tax liability were required. Due to the lack of actual income distributions and the terms of the partnership agreement, the Tax Court found that the children had no unrestricted right to enjoy the income from the limited partnership interests.

Price shows that the Tax Court stands by Hackl. Clearly, partnership agreements must be drafted carefully if gifts of partnership interests are intended to qualify for the annual exclusion. Provisions requiring the consent of the general partner, manager or other partners for transfer, withdrawal or redemption may prevent the gift to the donee from being a present interest. If a client insists on using such interests for annual exclusions, put options or withdrawal or redemption rights that are exercisable for a limited period of time may be necessary.

Fifth Circuit follows Eighth and holds that a loan receivable is not a qualified family-owned business interest under IRC Section 2057 — In Estate of Artall v. Comm'r, 105 AFTR 2010-___ (5th Cir. 2010), the Tax Court followed the U.S. Court of Appeals for the Eighth Circuit's holding in Farnam v. Comm'r, 583 F.3d 581 (8th Cir. 2009) and held that debt interests in the taxpayer's family farm may not count as qualified family-owned business interests (QFOBIs) for purposes of the deduction under IRC Section 2057.

Mary Roppolo Artall made eight unsecured loans to an LLC that owned livestock, farm equipment and supplies related to a family farm. The family farm was owned by a corporation, the shares of which were owned by Mary and her children. For estates of persons who died before Dec. 31, 2003, IRC Section 2057 provides an estate tax deduction for the value of QFOBIs — but only if the total value of the QFOBIs exceeds 50 percent of the decedent's adjusted gross estate.

Mary died in November of 2001 and her executors included as QFOBIs both her equity interests in the corporation and the LLC — along with the value of the outstanding debts — then deducted the value of QFOBIs under IRC Section 2057.

The IRS audited the return and asserted that the loans were not QFOBIs. Because Mary's equity interests in the corporation and the LLC alone did not exceed 50 percent of her adjusted gross estate, the IRS disallowed the deduction in full.

In its analysis, the Fifth Circuit reasoned that including debt interests would be inconsistent with the recapture provisions of IRC Section 2057. Under IRC Section 2057(f), an heir who disposes of any QFOBI within 10 years of the decedent's death is subject to tax on the value of the transferred QFOBI (plus interest). If debt interests are considered QFOBIs, this recapture provision automatically applies to an heir who receives payments on the loan. It seems unlikely that Congress would have intended IRC Section 2057 to allow a deduction for an interest that always would be subject to recapture.

Also, noting that the purpose of IRC Section 2057 was to help taxpayers avoid being forced to sell a family business, the court reasoned that an estate could transfer a loan receivable without jeopardizing the family business, or, if there was no secondary market for such loans, use other structures such as equity contributions and outside lending when obtaining financing.

In addition, the court was unconvinced by the estate's arguments based on statutory interpretation.

In the end, the Tax Court held for the IRS that the purpose of IRC Section 2057 was to allow a deduction for equity interests only and that the estate was not entitled to the deduction because its QFOBIs did not exceed 50 percent of the value of Mary's adjusted gross estate.

Canadian retirement account with holdings in U.S. corporations is not subject to U.S. estate tax — In IRS Legal Memorandum 201003013 (Sept. 30, 2009), a Canadian citizen, resident and domiciliary died owning a registered retirement savings plan (RRSP), a Canadian retirement account similar to an IRA. Contributions to an RRSP are tax deductible and the earnings are not subject to Canadian income tax until withdrawals are made.

The RRSP had Canadian mutual funds that were invested in U.S. corporations. The executor filed the appropriate Form 706-NA and after the return was selected for examination, requested the IRS to rule on whether the RRSP would be includible in the decedent's U.S. gross estate.

IRC Section 2101 imposes an estate tax on the taxable estate of non-resident non-citizens. But under IRC Section 2103, the gross estate of non-resident, non-citizens only includes property situated in the United States. Shares of stock issued by a U.S. corporation are deemed property situated in the United States under IRC Section 2104.

In this case, the issue was whether the RRSP would be deemed situated in the United States because its Canadian mutual funds held stock in U.S. corporations.

The IRS first cited Revenue Ruling 82-193, in which the corpus of a trust with a U.S. trustee established by a decedent for his benefit was not includible in his estate because the trust invested only in certificates of deposit, which IRC Section 2105(b) specifically deems not to be situated within the United States. In the Rev. Rul., the irrevocable trust was not relevant to the determination of whether the assets of the trust had a U.S. situs.

Applying the reasoning of Rev. Rul. 82-193, the IRS explained that the RRSP does not affect whether the underlying assets held by the RRSP are determined to have a U.S. situs. Instead, the issue was whether the Canadian mutual funds had a U.S. situs.

The IRS found that under the IRC Section 301 regulations, the mutual funds would be classified as corporations for U.S. tax purposes and, because they were not U.S. corporations, the mutual funds and the underlying assets should be excluded from the estate.

The IRS noted, however, that if the mutual funds had been classified as trusts for U.S. tax purposes, the mutual funds' holdings in U.S. corporations would have been includible, presumably because the mutual funds, as trusts, would have been ignored under the reasoning of Rev. Rul. 82-193 and the stock in the U.S. corporations would have had a U.S. situs.

PLR 201003013 shows that the classification of foreign mutual funds as corporations versus trusts may be determinative of whether the underlying assets have U.S. situs.

IRS to issue guidance for IRC Section 2511(c) — IRC Section 2511(c), applicable to transfers made in 2010, provides that “a transfer in trust shall be treated as a transfer of property by gift, unless the trust is treated as wholly owned by the donor or the donor's spouse” under the grantor trust provisions. This provision has caused some confusion among estate planners, because it could be interpreted to exclude transfers to wholly grantor trusts as taxable gifts or indicate that such transfers are not completed gifts.

Notice 2010-19 indicates the IRS will issue guidance under 2511(c) to clarify its meaning. The notice also explains that IRC Section 2511(c) was intended to be an addition to the other gift tax provisions of Chapter 12, and not to narrow or restrict the application of Chapter 12.

In other words, IRC Section 2511(c) applies to treat transfers to non-grantor trusts that otherwise would not have been taxable gifts under Chapter 12 as taxable gifts if made in 2010. But this “expansion” of taxable gift treatment does not extend to transfers to grantor trusts — transfers to those trusts still are subject to the same rules under Chapter 12.

Amount paid to a charity pursuant to a settlement agreement is not deductible — In Technical Advice Memorandum 201004022, the IRS held the amount paid to a charity pursuant to a settlement agreement wasn't deductible from the estate because the charity didn't have an enforceable right under state law to the amount it received.

The decedent's will established a charitable trust and devised real estate and certain sums to trusts for the decedent's relatives. Each trust terminated at the end of the respective beneficiary's life and the remainder was to be paid to the charitable trust. In addition, an in terrorem clause provided that the share of any person who contested the will was to be paid to the charitable trust. But the decedent's will mistakenly did not dispose of the residuary of his estate.

The decedent's only son claimed that the residue, because it was not disposed of by the will, should pass by intestacy to him. The charitable trust argued that the omission was a scrivener's error and that the decedent intended the charity to receive the residue. The dispute was settled, a local court approved the settlement agreement, and the decedent's son paid the charity a certain sum.

The IRS held that, because the will was silent regarding the disposition of the residue, it should pass by intestacy. Even though the failure to include a residuary clause was unintentional, after reviewing decisions made by local courts, the IRS concluded that a court would not substitute a residuary beneficiary to fill the omission. Therefore, the charitable trust had no enforceable right to the residue and the estate was not entitled to a deduction for amounts the charitable trust received pursuant to settlement.