Net, Net Gifts: Donee Assumption of Section 2035(b) Tax Liability
Steinberg v. Commissioner, 141 T.C. No. 8, Code Sec. 2035(b), 2512(b)
Issued September 30, 2013
Author: Kerry Reilly, Esq.
In April 2007, Jean Steinberg (“Taxpayer”) entered into a “net gift agreement” with her four adult daughters. Under the net gift agreement, Taxpayer made gifts of cash and securities to each of her four daughters (“Donees”). In exchange, the Donees agreed to assume responsibility for any federal gift tax imposed as a result of the gift and any federal or state estate tax imposed on the gift under Section 2035(b) in the event the Taxpayer passed away within three years of the gift.
Taxpayer filed a timely Form 709 for tax year 2007 reflecting a net gift amount of approximately $71.6 million and total gift tax of approximately $32 million. An appraiser, hired by the Taxpayer, calculated the amount of the net gift by reducing the fair market value of the gift by (1) the gift taxes paid by the Donees and (2) the actuarial value of the potential Section 2035(b) estate tax (approximately $5.84 million).
The Internal Revenue Service (IRS) mailed a notice of deficiency disallowing Taxpayer’s entire discount for the Donees’ assumption of the potential 2035(b) tax liability ($5.84 million) and increasing the gift taxes due by approximately $1.8 million.
The IRS requested a summary judgment on one issue only – whether a Donees’ promise to pay any federal or state estate tax liability that may arise under Section 2035(b) may constitute consideration in money or money’s worth within the meaning of Section 2512(b). (emphasis added)
Discussion and Analysis:
Under Internal Revenue Code Sec. 2035(b), the decedent’s gross estate is increased by the amount of any gift tax paid by the decedent or the decedent’s estate on any gift made by the decedent during the three years prior to the decedent’s death. Under Internal Revenue Code Sec. 2512(b) the amount of the gift is the amount by which the value of the transferred property exceeds the value of the consideration received in money or money’s worth.
The IRS claimed that the Donees’ assumption of the potential Section 2035(b) estate tax failed to build-up or contribute to (“replenish”) Taxpayer’s estate, (monetarily or otherwise) providing only “peace of mind” and therefore failed as consideration under the “estate depletion” theory of gift tax. The “estate depletion” theory determines what constitutes consideration in money or money’s worth. If a donor’s estate has not been replenished, then that donor has not received consideration. The IRS rested its claims in part on the Tax Court’s holding in McCord v. Commissioner, 120 T.C. 358 (2003), rev’d and remanded sub nom. Succession of McCord v. Commissioner, 461 F.3d 617 (5th Cir. 2006) ((a) donees’ assumption of the taxpayer’s 2035(b) estate tax liability was too speculative to be reduced to monetary value and (b) any benefit from the donees’ assumption of the Section 2035(b) tax liability would accrue to the donor’s estate rather than the donor).
The Court agreed with the Court of Appeals and reversed its position in McCord with respect to the “too speculative” claim. It held that assumption of the potential Section 2035(b) tax liability was not too speculative because a “willing buyer and seller in appropriate circumstances may take into account a donee’s assumption of [this] liability in arriving at a sale price.” The Court noted that “many courts have held that the value of stock received by gift or bequest must be reduced by capital gains tax regardless of the lack of indication that the capital gains will be triggered by the donee or beneficiary in the near future.” E.g. Estate of Jelke v. Commissioner, 507 F.3d 1317, 1319, 1333 (11th Cir. 2007). The Court also noted that these cases show it is possible to determine the value of built-in capital gains on the valuation date despite the uncertainty of surrounding factors (i.e. rates, potential repeal of tax, future sale/trigger date, amount of tax due from beneficiary/donee, etc.) and that there is a “possibility that an appropriate method may likewise exist to fix the value of the potential Section 2035(b) estate tax liability…”
The Court also reversed its position on McCord with respect to the “estate depletion” theory. It held that its prior distinction between a donor and his/her estate was incorrect and that “they are inextricably bound.” The Court also reasoned that when the Donees assumed the gift tax liability the Taxpayer’s assets were “replenished” by the amount of the gift tax liability assumed by the Donees because the “consideration may discharge [the donor] from liability…the benefit to the donor in money or money’s worth, rather than the detriment to the donee determines the existence…of consideration.” Commissioner v. Wemyss, 324 U.S. 303, 306-308 (1945). The Court reasoned that likewise the assumption of the liability for the potential 2035(b) tax by the Donees may also replenish the Taxpayer’s assets because the Taxpayer’s estate would be relieved of that liability.
The IRS’ motion for summary judgment was denied. The majority opinion stated that IRS failed to show, as a matter of law, that the Donees’ assumption of the Taxpayer’s potential Section 2035(b) estate tax liability cannot be considered money or money’s worth within the meaning of Section 2512(b). The majority also held that there were disputes of material fact with respect to whether the Donees’ assumption of potential Section 2035(b) estate tax liabilities constituted consideration in money or money’s worth. The majority did not enumerate any of these issues however.
A concurring opinion stated that this holding creates a potential valuation issue for the future – that the legal obligation of the Donees to pay the Section 2035(b) estate taxes could be considered an “asset” of the Taxpayer’s estate. This new asset may result in a windfall to the Donees if the Taxpayer does not die within the three-year period, or could result in the Donees potentially paying an amount in estate taxes that is greater than the discount received.
A second concurring opinion stated that with respect to the “too speculative” theory, neither party had asked the Court to consider that issue, thus the Court’s discussion of that point was premature. This concurring opinion reflected that with respect to the “estate depletion” theory, the IRS may be able to show that the Donees agreement to pay the Section 2035(b) taxes did not in fact increase the Taxpayer’s estate and was in fact merely (1) a way to apportion the tax within the estate and among the beneficiaries as the Donees will “pay” the taxes either as part of the net gift agreement or in the receipt of a smaller inheritance (if the taxes were paid by the Taxpayer’s estate), and further that (2) the net gift agreement simply memorializes an obligation that the Donees have under New York State law, thus the value of the net gift agreement as it relates to the Section 2035(b) obligation is merely as a “enforcement mechanism.”
The dissenting opinion provides numerous calculations detailing the difference in gift and estate tax amounts due for the gift and net, net gift scenarios if the taxpayer dies within three years of making the gift. These calculations are provided as illustrative examples that the allowance of the Section 2035(b) payment by the Donees is contrary to Congress’ purpose in enacting Section 2035(b), i.e. to mitigate in part a disparity between the tax bases subject to the gift and estate tax, respectively. The opinion provides that the allowance of the deduction for the potential Section 2035(b) taxes “allows the transferor to render more lenient the gift taxation (if no Section 2035(b) liability arises) and the estate taxation [(if that liability does arise)].”