Estate & Gift
Tax
Bogdanski
Fall 2012
Sample Answers to Question 2
Exam No. 3960
2012 Gifts:
The 13k gifts use up Patty's 13k 2503(b) annual exclusion for 2012 for each N. Patty's transfer of stock also constituted completed gifts in 2012 per FIND REG HERE. The valuation clauses in the transfer documents are a classic example of value adjustment clauses but keyed on the unified credit rather than the annual exclusion. In fact, a clause similar to this with the excess of tax-free value going to a charity was upheld in Petter v. Commissioner. While the language leaves some question as to whether a gift was made from P to Ns and then from Ns to charity, the fact that Ns never had the excess shares free and clear of P's control indicates that the two transfers should be combined and treated as one. Thus the value adjustment clause works and the transfer to Ns uses up the unified credit and the transfer to the Red Cross gets the charitable deduction per 2522 since the stock is transferred as undivided interest. Thus the gifts in 2012 are all tax free (but the unified credit is used up assuming the exemption amount is $5m as stated in the question).
2016 Transfer:
Patty's infusion of $500k into upco counts as a gift to upco's other shareholders per Reg. 25.2511-1(h)(1). The gift is calculated as proportional to the percentage of ownership share. Thus 60%, Patty's share, of the 500k (or 300k) is not a gift since once cannot give oneself a gift. The two Ns, since owning 20% shares each, each received a gift of 100k. The annual exclusion likely won't apply since courts have ruled that gifts of this type constitute future interests. If the underlying asset of which an interest is given does not provide a substantial present economic benefit, then the gift is not a present interest and does not get the 2503 annual exclusion. Present economic benefit requires the underlying asset to produce income and that some ascertainable portion of that income will flow to the donee. Upco does not pay dividends. Thus Patty's gift of the capital infusion into the company is not present since no income is generated for the Ns. Hence the full 200k gifted will be taxable to P at 35% since no annual exclusion is allowed and no unified credit remains.
The Notes as Gifts:
The promissory notes were completed gifts in 2016 as long as they were binding and legally enforceable at that point. The fact that they would not be paid out until a later date does not alter their status as complete - any delay in fulfilling the obligation is immaterial as long as the obligation is binding and legally enforceable per Copley. However as a pure gift without any consideration, these "contracts" seem unlikely to be binding and legally enforceable under state law. If that is the case, the gift would not be complete, and gift tax not due, until the amounts were actually paid.
P's Death:
P's stock of 60% will not be discounted for lack of control since the estate is valued as a whole - the "slicing and dicing" technique to lower valuation through minority discounts only works for gifts - the fact that the Ns only receive 30% each is not material in the estate context. However, the 60% stock will likely still get a blockage discount since it represents so much of the same item that if it were dumped into the market as a block it would not sell quickly or easily. Furthermore, there may be a lack of marketability discount if this company is subject to closely held corporation stock rules.
Assuming that P's probate estate consists of undivided interests, it being left to charity will get the 2055 charitable deduction and thus will not be taxed.
The payment of debts and estate expenses will likely also be deducted under 2053(a). The expenses count for deduction so long as they are allowable under state law and are actually and necessarily incurred in the administration of the estate. The debts count for deduction so long as they existed before P's death and were incurred for full and adequate consideration in money or money's worth per 2053(c)(1)(A). That means that since the claims by the two Ns were not incurred for full and adequate consideration, their payment will not be deductible under 2053.
Furthermore, if P paid gift tax on the notes in 2016, that gift tax paid will be brought back into the gross estate under the gross-up rule of 2035(b) since it was paid in the last three years of P's life: the inclusion/exclusion advantage of gifting or bequeathing is recaptured.
Exam No. 3740
There are no GST tax consequences in this problem bc there are no skip people as defined in § 2613.
In 2012, Patty's transfer of $13,000 cash to N & N is a complete gift (transfer for no consideration, relinquished all dominion & control over the cash). Because giving cash is a gift of a present interest, P could use her annual exclusions to offset any tax liability she would have on them.
Patty also made a gift to N & N when she transferred Upco stock to them. She included a Petter-like value adjustment clause into the transfer instrument, which was a smart thing to do. The 9th circuit has upheld this kind of clause, even though the IRS hates them. Thus, if this kind of clause works again, P won't owe any gift tax on this transaction because even though it turned out she transferred more than her annual exclusion to N & N, they transferred the excess to charity. The extra $625,000 that N&N ended up having to transfer to the American Red Cross would not be taxable to any of them, because it is a charitable contribution under § 2522. Thus, it would go on a gift tax return, but would then be offset by the charitable contribution ded'n.
In 2016, when Patty transfers $500,000 capital to Upco, she makes a completed indirect gift to N&N. First off, the transfer doesn't qualify for the bona fide business transxn exception because it likely isn't bona fide & at arm's length. § 2511provides that gift tax is imposed on indirect gifts just as well as direct gifts. A transfer to a family owned corp is the classic indirect gift & is discussed in Reg. § 25.2511-1(h)(1). When one of the owners of the corp transfers money to the family corp but doesn't take any more interest or other consideration out of the corp, it is a gratuitous transfer. P will have to pay gift tax on this transfer since she has used up her unified credit already. This would be likely be considered a transfer of a present interest to N&N since they are partial owners of the corp and could access the money. As such, P can likely use her $13,000 annual exclusion toward each of these gifts. If it is considered a transfer of a future interest bc N&N don't have a controlling share of the corp, then P wouldn't be able to use any annual exclusion toward these gifts. The amount of the gifts would be N&N's proportional interest in the corporation, or 40% of the value of the transfer.
The transfer of the promissory note to N&N would be an incomplete gift to them because P could still default or revoke on it. Thus, no gift tax consequences.
When P dies in 2017, all of the gift tax she paid in 2016 for her transfer to the corp will be pulled back into her gross estate under § 2035(b). Everything she owned at death will be included in her gross estate under § 2033. The value of the $100,000 promissory note will also be included in P's gross estate because even though the trustee treats it as if it were a claim against the estate (which, if it were a valid claim, would be a ded'n under § 2053), it is not a valid claim. With regard to contractual gifts, there must have been full & adequate consideration for the contract for it to be considered a valid claim. Tehre was no such consideration here because P transferred the PN gratuitously. This means no ded'n to offset the value of the PN. P's estate will get to take a ded'n for her charitable contribution to Red Cross under § 2055. Since it was an outright gift, there is no worry about a time-divided interest messing up her ded'n. The ded'n will offset the value of what is included in her gross estate under § 2033.
Lastly, there will need to be some valuation done to determine the value of what P left to N&N. P still held a controlling interest in the corp, so her estate will not get to take a lack of control discount. However, it will get to take a lack of marketability discount since this is a closely-held corp. It is unlikely that she can take a blockage discount since this is not a publicly-traded company.
The timing of valuation will depend on whether her estate elects to valuate the estate at P's death (default) or six months later under the § 2032 alternate valuation date. The estate can only choose § 2032 if valuing the estate six months later will decrease the value of her gross estate and decrease her tax liability (no basis games allowed here).
Exam No. 3286
NOTE: there do not to be any GST issues implicated by this fact scenario as Patty's nieces are not "skip people."
NOTE: on all of the gifts I discuss below, I want to note that no consideration changed hands, so it was a gift.
NOTE: I assumed unified credit of $5 mil for purposes of this Q (even though I now realize it's really at $5,120,000)
1. 2012, gives $13K cash to each of Nell and Norah
Because the gifts of $13K each are transfers of property that are complete when Patty hands the cash over, they are gifts. However, when Patty gives $13K to each of Nell and Norah in 2012, those gifts qualify for the annual exclusion for gift tax purposes. The annual exclusion is codified in 2503(b) and provides that in the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year the first $13K (this is an inflation adjusted number) of such gifts to such person shall not be included in the total amount of gifts made during such year. The annual exclusion applies separately as to each donee, so Patty can use the annual exclusion for the $13K to Nell and can also use the annual exclusion for the $13K to Norah. Thus, there is no gift tax consequence of the cash gifts.
2. 2012, gifts of stock to Nell and Norah (formula clause w/ excess to charity if audit values them higher)
I first want to note that because the gifts of stock are made during 2012, Patty cannot use the annual exclusion toward the gifts of stock b/c she's already used up her annual exclusion for each of Nell and Norah in 2012.
First, these appear to be completed gifts because the facts say Patty makes "gifts of stock." Stock is property and it appears it was actually transferred because the tehre are transfer documents according to the facts of the question. It's useful to determine whether the gifts are actually completed for purposes of the gift tax. The regs say that as to any property of which the donor has so parted w/ dominion and control as to leave in him no power to change its disposition, a completed gift has occurred. P has clearly gifted the stock away, and if the value of the stock is challenged on audit and determined to be higher, P isn't going to get the stock back - it's going to charity, so she seems to have irrevocably made a disposition of the stock. There is no way it's coming back to her. Therefore, it appears this gift is complete.
The question is what the value of the gift is. 2512(a) provides that if a gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift. Because Patty had a stock appraisal conducted and it was determined that the value of the stock for federal gift tax purposes was $1,000 per share, then the value of the gift to each niece is $1,250,000 (total of $2,500,000). There is a question as to whether the strategy Patty used with a conditional gift to the nieces causes the value of the gifts to actually be higher than she reported for gift tax purposes. Patty has used a value adjustment clause in her gift of stock that provides that if a gift tax audit determines the stock is actually worth more than it was reported as being worth for gift tax purposes, then stock equal to the excess value shall go to charity (the Red Cross). While it would seem that Patty should face a gift tax liability on the $625K excess value of the stock, she's not going to face a gift tax liability in all likelihood. Here's why.
The total gifts to the nieces were in the aggregate $2,500,000. Because Patty used her annual exclusion up earlier in 2012, she can't use that for the gifts to N and N. Further, she cannot use a deduction for the gifts to N&N b/c they are not a charitable beneficiary or married to Patty. So, Patty's taxable gifts are worth $2,500,000. However she still has $2,500,000 of unified credit left over to use up, and that just so happens to be exactly equal to the amount of her gift to N & N. Therefore, she's not going to be liable for any gift tax on the gift of stock. When the value was challenged by the IRS auditors and redetermined to be $250 higher per share of stock transferred, Patty transferred the excess stock worth $625K to the Red Cross. While this would seem to be a gift (because it is a complete transfer of property at that point), Patty gets to take a deduction for the gift, and because the Red Cross is a charity (I am assuming for purposes of this problem that they are a charity as defined under 501(c)(3)), she's going to get a charitable deduction for the transfer. In order to qualify for the charitable deduction, she gets to deduct from the value of the taxable gift ($625K) the amount of her gift to or for the use of any corporation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes...and the red cross is operated exclusively for charitable purposes around the world (providing first aid in times of need and emergency) and educational purposes (educating people on how to perform CPR). Importantly and significantly, this exact type of arrangement has been upheld in the 9th Circuit Court of Appeals as being legitimate, so if P is in the 9th Circuit, she should be golden. If she's in another circuit, I think it's going to be hard for the tax court to disallow the charitable deduction since the gift to charity meets the exact terms of the deduction. It's possible (depending on when the issue is being litigated) that the fact that the company bought the shares back from the Red Cross for cash will be even stronger evidence that there was some sort of tax evasion purpose associated with this whole scheme, but I still think that the company can argue that it was prudent to purchase the shares back from the Red Cross because (1) it eliminated having an extra shareholder out there who wasn't in the family (and family businesses like to keep the business in the family which is a legitimate business reason), and (2) the Red Cross benefitted from the redemption of its stock because it got the cash outright, which is great because it can use that cash for its charitable functions.
Therefore, I think it is highly likely that P will not face any gift tax liability for the gifts of stock to N&N and the subsequent gift of shares to the Red Cross.
3. 2016 - Capital Contribution ($500K) (60% P, 20% N, 20% N)
When Patty makes a capital contribution to the corporation, the contribution is not being made pro-rata (meaning that N and N are not each contributing what would be their pro-rata portion of a capital contribution into the corporation as well). This could be a deemed gift from P to each of N and N in proportion to the relative share ownership of each party (so P would be deemed to be making 60% of the contribution on her own behalf (or $300K) and then 20% of the contribution ($100K) for each of N and N. There is in this situation a transfer of property (contribution of money) to the corporation and in exchange, P is not taking anything out of the corporation. Reg 25.2511-1(h)(1) provides that the transfer of property by a shareholder to a corporation represents a gift by the transferor shareholder to the other individual shareholders of the corporation to the extent of their proportionate share of the corporate stock. There are no facts in this situation to suggest that the gift is incomplete for any reason, and therefore it appears that P's capital contribution to the corporation is a completed gift from P of property worth $100K to each of N and N. This property seemingly would be eligible for the annual exclusion because on its face a gift of stock seems like a gift of a present interest (a gift of stock is a present right in and to the corporate stock of the company and the income generated by that stock). However, because the company does not pay dividends on its stock, it is possible that the court would hold this is not a gift of a present interest and thus not eligible for the annual exclusion. This is similar to the Maryland National case where the decedent owned an interest in a Partnership that owned non-income producing land on which no income had ever been generated. So, it's possible the tax court would say that this stock is similar to the partnership interest in that case, and that because the shareholders didn't receive any dividends on the stock, it's really a gift of a future interest and not a present interest. The fact that each shareholder is receiving substantial salaries from the corporation may help to argue that the shareholders are receiving some benefit (but this may be a tenuous argument since the shareholders are receiving compensation for working at the company). Thus, I think this one may not be eligible for the annual exclusion. It's really a toss-up.
4. 2016 - Gift of Note payable by Patty for $100K w/ market interest payable in 2018
I was a little confused by Patty giving her note to the girls - I didn't see in the facts where it said how the note came to exist. For purposes of my analysis, I'm going to assume that the note was an obligation someone owed Patty and that essentially Patty assigned it to the girls. This is a completed gift for gift tax purposes because it is a transfer of property (of a negotiable instrument) to the nieces and there is no consideration flowing from the nieces back to Patty. Because the gift isn't payable until 2018, it's not a gift of a present interest and so Patty cannot use the annual exclusion. Therefore, this will be considered a taxable gift from Patty to the girls and will be valued at its present value at the time of the gift (the tax system doesn't care how hard it is to value something - they make you find a value and tax it now). The note should be relatively easy to value because it has a face amount and a market rate interest, so the tables in the 7000 something of the code will allow the note to be presently valued.
5. 2017 - death -
30% stock to each of N & N
rest of estate to Red Cross
NOTES PAID OFF by estate
When Patty dies, she leaves her stock 30% to each of N & N, and the remainder to the Red Cross. The estate tax is imposed on the value of the gross estate. The value of the stock is clearly includible in her gross estate under 2033. Section 2035 provides that gifts made within 3 years of death can in certain cases be pulled back into a decedent's gross estate and taxed. This could pose a problem for Patty because she made two gifts within 3 years of death - the capital contribution to the Corporation (deemed gift of $100K to each of N & N) and the gift of the $100K FV + MV interest note to her nieces w/in 3 years of her death. The test to determine if one of these things goes into the gross estate is as follows: D made a transfer of an interest in property during 3 year period ending on date of death. This is satisfied b/c P transferred her interest in the note and also transferred cash in 2016 (which is within 3 years before her death). Second, the value of the property would have been included in D's gross estate under 2036, 2037, 2038, or 2042 if the power had been retained by the D on date of death. Here, it doesn't appear P retained an interest in either the note or the capital contribution. Further, D did not retain a reversion. In addition, D did not have the power to alter, amend, revoke or terminate (although arguably maybe she did with the capital contribution b/c she was the majority shareholder and could thus force a distribution to herself). Finally, the transfers weren't of life insurance. Therefore, the value of those gifts will likely not be included back into D's estate. However, 2035(b) will pull the gift tax D paid on the capital contribution (gift tax on $200K) and the gift of the note (gift tax on $100K) back into her gross estate b/c those gifts were made w/in 3 years of death.
Patty's estate will not be eligible for a marital deduction, but will be eligible for a charitable deduction in the amount the bequest to the Red Cross b/c the Red Cross (as discussed above) is a charitable beneficiary. Finally, the estate may try to argue for a deduction for the notes paid off by the estate by arguing that the notes were a claim against the estate. However, 2053(c)(1)(A) provides that if there was no bona fide contract for adequate and full consideration, then the estate does not get a deduction for a claim against the estate. Therefore, b/c the note was a gift and was not contracted for with a full and adequate consideration, there will be no deduction.
Finally, the stock in P's estate will be valued by determining how much a wiling buyer and willing seller, both being under no compulsion to buy, would pay for it. The estate will likely be able to take a discount for lack of marketability because the company is a closely held entity. However, the estate won't get a minority interest discount b/c P was the controlling shareholder at death.
Note if something horrible happens and the value of P's assets significantly declines just after she dies, the estate can elect the alternate valuation date.