Tax Law Update 2011-07-01 (1)Tax Law Update 2011-07-01 (1)

Ninth Circuit affirms Tax Court that assets transferred to family limited partnership (FLP) are includible in decedent's estate — In an unpublished memorandum decision dated May 4, 2011, the U.S. Court of Appeals for the Ninth Circuit affirmed the Tax Court's 2009 decision in Estate of Erma V. Jorgensen v. Commissioner, TC Memo 2009-66 (March 26, 2009).

Erma Jorgensen died in 2002, owning interests in two FLPs. The first, JMA-I, was formed in 1995 by Erma and her husband, Colonel Gerald Jorgensen, a highly decorated bomber pilot who served in both World War II and the Korean War.

Erma and the Colonel each contributed marketable securities to JMA-I. In exchange, Erma received limited partnership interests and the Colonel received limited and general partnership interests. In addition, even though their children and grandchildren didn't make any contributions, the children were listed as general partners (GPs), and the grandchildren were listed as limited partners (LPs). The Colonel organized the formation of JMA-I independently of the other family members — Erma and the children weren't involved in negotiating the terms of the partnership — and the Colonel managed the partnership assets exclusively without any involvement by the other GPs.

After the Colonel's death, Erma established a second FLP, JMA-II. Erma contributed her own marketable securities and cash and, as executor, marketable securities and cash from the Colonel's estate, in exchange for partnership interests. Again, the children and grandchildren made no contributions but were listed as GPs and LPs, respectively. Evidently, the children and grandchildren received these partnership interests by gift, but Erma never filed gift tax returns to report them (some of the gifts exceeded her gift tax annual exclusions).

The FLPs continued to own only cash and marketable securities. Neither Erma nor her children actively managed the FLPs. The partners didn't keep formal books or records, and there was no oversight of the accounts (for example, no one reconciled the partnership bank account statements). Erma withdrew funds and wrote checks from the partnership accounts even though, as an LP, she had no authority to do so, and the partnership agreements required pro rata distributions. Erma used partnership funds to pay her income taxes and other personal expenses. After Erma died, partnership funds were also used to pay administration expenses and taxes for her estate and the Colonel's estate.

The Tax Court ruled that the assets Erma transferred to the FLPs were includible in her gross estate under Internal Revenue Code Section 2036(a)(1), because her inter vivos transfer of assets to the FLP wasn't a bona fide sale for adequate and full consideration, and she had retained the possession or enjoyment of, or the right to the income from, the transferred assets. The estate appealed to the Ninth Circuit, arguing that (1) the benefits Erma retained were de minimis, (2) the Tax Court erred in concluding that there was an implied agreement that Erma could access any amount (rather than some limited amount) of the transferred assets, and (3) the Tax Court erred in determining that Erma's transfer wasn't for full and adequate consideration.

In a short memorandum opinion, the Ninth Circuit held against the estate on all issues. The court wasn't convinced that the payments for Erma's benefit and her estate taxes were de minimis. And it held that the Tax Court didn't clearly err by concluding that there was an implied agreement that Erma could have accessed any amount, because the checks that were written on the partnership account indicated that she had access to partnership funds. It also agreed with the Tax Court that the disregard for partnership formalities, along with the fact that the partnership was funded with marketable securities, indicated that the partnership was a mere “recycling of value” without a legitimate and significant non-tax reason. As a result, the funding of the partnership wasn't a bona fide sale for adequate and full consideration.

Estate denied deduction for malpractice claim as the value was unascertainable under IRC Section 2053 — In Estate of Gertrude H. Saunders v. Comm'r, 136 T.C. No. 18 (April 28, 2011), the Tax Court held that an estate wasn't entitled to deduct the value of a legal malpractice claim, because the value of the claim wasn't ascertainable with reasonable certainty.

Gertrude Saunders, a resident of Hawaii, died on Nov. 27, 2004. Her husband William W. Saunders, Sr. (Saunders), a lawyer, died in 2003. While practicing, Saunders represented Harry S. Stonehill. Years later, Stonehill was involved in extensive tax litigation and his lawyers ultimately discovered a memorandum from 1960 that indicated that Saunders had acted as a secret Internal Revenue Service informer against Stonehill and had disclosed that Stonehill had accounts in Switzerland. Stonehill's lawyers took the case on a contingency basis and continued to investigate the claims even after Stonehill died in 2002. The lawyers eventually filed a demand letter on Saunders' estate in mid-September 2004 and a complaint requesting over $90 million in compensatory damages (and additional punitive damages) in the U.S. District Court for the District of Hawaii. Gertrude died in November 2004, trial preparation continued and settlement negotiations were entered into, but no settlement was ever reached. After a six-week jury trial that started in May 2007, the jury found that Saunders had breached his fiduciary duty, but that the breach wasn't a legal cause of injury or damage. Ultimately, the Saunders estate paid $250,000 in attorney's fees to Stonehill's estate.

Gertrude's estate filed an estate tax return on Feb. 23, 2006, claiming a deduction of $30 million under IRC Section 2053 for the value of the malpractice claim. (Her husband's estate claimed the same $30 million deduction on its estate tax return but received a closing document that stated that the value of the malpractice claim would be resolved in Gertrude's estate.) The IRS audited the estate and issued a notice of deficiency that allowed a $1 deduction for the malpractice claim.

Treasury Regulations Section 20.2053-1(b)(3), as in effect on the dates of Gertrude's death in 2004 and Saunders' death in 2003, provided that an item may be entered on the return for a deduction though its exact amount isn't then known, provided it's ascertainable with reasonable certainty and will be paid. The Treasury regulation section further provided that liabilities imposed by law or arising out of torts are deductible.

The court agreed with the IRS that the value of the malpractice claim wasn't ascertainable with reasonable certainty and therefore couldn't be deducted on the estate tax return. The court didn't address whether the post-death settlement could be taken into account when determining the value of the claim. Instead, it found that the value of the claim was unascertainable based on the discrepancy between the various appraisals and valuations submitted by the experts.

The estate's experts estimated the value of the claim to be between $19.3 million and $30 million, which the court found to be a prima facie indication of lack of reasonable certainty. The court noted that one expert acknowledged that the probable range of jury damages awards could be from $1 to $90 million, while another expert's report was “fraught with vague and uncertain guesstimates.” As a result, the court agreed with the IRS that the estate couldn't deduct the value of the contingent claim under IRC Section 2053; instead, it could only deduct the amount actually paid during the administration of the estate.

This case underscores the importance of obtaining consistent and focused appraisals for hard-to-value claims or assets.

Transfers pursuant to settlement agreement not subject to gift tax — In Private Letter Ruling 201119003 (May 13, 2011), the IRS ruled that an exchange of property interests between the trustees and remaindermen of a marital trust wasn't a transfer subject to gift tax or a disposition of an interest under IRC Section 2519.

The decedent and the decedent's first spouse (Spouse 1) established a revocable trust. After Spouse 1 died, the decedent married Spouse 2 and then amended and restated the revocable trust. On the decedent's death, a marital trust was established for the benefit of Spouse 2, for which a qualified terminable interest property (QTIP) election was made under IRC Section 2056(b)(7). Upon Spouse 2's death, the remaining property in the marital trust was to be distributed to trusts for the benefit of the decedent's descendants (who were the issue of the decedent and Spouse 1).

The marital trust co-owned partial interests in many entities. The decedent's children were the other co-owners. The entities held commercial real estate. One of the decedent's children served as a manager, managing member or general partner of at least eight of these entities.

Two years after the decedent's death, the decedent's children filed a petition in state court for a trust accounting with respect to the marital trust. The trustees of the marital trust then filed a petition to establish its ownership interests in the various entities, which the children disputed. The state court ordered the trustees and the children to participate in mediation. The mediation resulted in a settlement among the trustees and children resolving the trust accounting and administrative issues raised by the children. In addition, the settlement agreement proposed an exchange of interests in the various entities to end the co-ownership among the trustees and the children. The trustees would purchase interests in certain entities owned by the children so that the trustees would own 100 percent of these entities; the children would purchase certain interests in other entities from the trustees so that they would own 100 percent of these other entities. The value of the interests was to be set by an average of the fair market values (FMVs) determined by two appraisers selected by the judge who presided over the mediation. To the extent that the aggregate FMV of the purchases by the trustees exceeded the aggregate FMV of the purchases by the children, the trustees would make an equalizing payment to the children, and vice versa.

The transfer of an income interest in a marital trust is subject to the general gift tax provisions of IRC Section 2511. In addition, IRC Section 2519(a) provides that for gift and estate tax purposes, any disposition of all or part of a qualifying income interest for life in marital deduction property shall be treated as a transfer of all interests in such property other than the qualifying income interest.

However, Treas. Regs. Section 25.2519-1(f) provides that converting a QTIP into other property in which the donee spouse has a qualifying income interest for life isn't treated as a disposition of the qualifying income interest.

The IRS ruled that the exchange of interests in the entities wasn't a gift subject to gift tax under IRC Section 2511 because the transfers were the result of a bona fide adversarial proceeding and arm's length negotiations. To the extent payments made and received in the exchange were distributed in accordance with each party's respective ownership interest, as properly determined under applicable local law, the IRS concluded that the transfers were made for adequate and full consideration in money or money's worth and wouldn't be subject to the gift tax. And, the sale and reinvestment of the marital trust assets wasn't a disposition of the qualifying income interest under IRC Section 2519, because Spouse 2 continued to have a qualifying income interest for life in the trust after the sale and reinvestment.