LEGISLATIVE UPDATE

Court Rules FLP Assets Includible in Estate, Allows Estate to Recoup Overpaid Income Taxes

On March 26, the U.S. Tax Court determined in the Estate of Jorgensen v. C.I.R. (T.C., No. 21936-06, T.C. Memo. 2009-66, 3/26/09) that assets the decedent, Erma V. Jorgensen, transferred to two family limited partnerships during her lifetime were includible in her gross estate for federal estate tax purposes under I.R.C. § 2036. However, the court allowed the estate to recoup income taxes paid by the decedent's children and grandchildren as a result of using the decedent's original cost basis to calculate the gain on the sale of those assets rather than the stepped-up basis under I.R.C. § 1014(a), even though the request for refund was untimely.

Ms. Jorgensen died in April 2002 a resident of California. At the time of her death, her will named her daughter, Jerry Lou Davis, as executrix of her estate; Jerry Lou and Ms. Jorgensen's son, Gerald R. Jorgensen, Jr., were named co-trustees of her revocable trust. Over the course of her marriage to Colonel Gerald Jorgensen, the couple accumulated a portfolio of marketable securities valued at over $2 million. In 1995, the couple formed a family limited partnership called the Jorgensen Management Association (JMA-I). Each spouse contributed marketable securities valued at $227,644 to JMA-I in exchange for a 50-percent limited partnership interest. The agreement named Colonel Jorgensen, Gerald and Jerry Lou general partners, with Gerald, his three children, Jerry Lou, and her three children listed as limited partners. Neither the Jorgensen's children nor grandchildren made a contribution to the partnership. In 1996 Colonel Jorgensen passed away, and his estate claimed a 35% discount on his interest in JMA-I.

In 1997, JMA-II was formed with Ms. Jorgensen making a contribution of $1,861,116 in marketable securities in exchange for her initial partnership interest. After subsequent contributions were made from her personal assets as well as assets from Colonel Jorgensen's estate, Ms. Jorgensen held a 79.6947-percent interest in JMA-II, and Colonel Jorgensen's estate held a 20.3053-percent interest. Neither the couple's children nor grandchildren contributed to JMA-II although the partnership agreement named Gerald and Jerry Lou general partners, and Gerald, Jerry Lou, and the grandchildren as limited partners. Even though the partnership interests exceeded the $10,000 gift tax exclusion in effect at the time, gift tax returns were not filed.

Neither partnership operated a business, holding only passive investments consisting primarily of marketable securities, nor did either partnership maintain formal books or records. According to the partnership agreements withdrawals could only be made by general partners. However, Ms. Jorgensen was authorized to write checks on the JMA-II checking account. Over the next two years she wrote checks on both the JMA-I and JMA-II accounts, with some of the withdrawals used to make gifts to family members. She also used the JMA-I account to pay her 1998 quarterly estimated federal and state income taxes, and co-mingled partnership and personal funds in other ways. Again, gifts were never reported on a gift tax return, although some were required to be reported.

After Ms. Jorgensen's death in 2002, JMA-II paid $179,000 in federal estate taxes and $32,000 in California estate taxes on behalf of her estate. In 2003 through 2006, the partnerships sold various assets, including stock which Ms. Jorgensen had contributed to the partnerships during her lifetime. In computing the gain on these sales, the partnerships used Ms. Jorgensen's original cost basis in the assets rather than the stepped-up basis equal to their fair market value on the date of her death under I.R.C. § 1014(a). These gains were reported by the partnerships on their respective income tax returns, and the partners paid the resulting income taxes. The IRS determined a $796,954 federal estate tax deficiency against the estate, claiming the value of the assets transferred to the partnership should be included in the estate under I.R.C. § 2038.

The court applied I.R.C. § 2036 rather than § 2038, noting "[s]ection 2036(a) is applicable when three conditions are met: (1) The decedent made an inter vivos transfer of property; (2) the decedent's transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which the decedent did not relinquish before her death. If these conditions are met, the full value of the transferred property will be included in the value of the decedent's gross estate." The estate, however, claimed that Ms. Jorgensen's transfers of securities to the partnerships were not "transfers" under § 2036 (a) claiming the transfers were bona fide sales for full and adequate consideration because the decedent had several nontax reasons for making the transfers including management of her assets, financial education of family members, and perpetuation of the Jorgensens' investment philosophy.

The court rejected these arguments, stating that after considering the "the totality of the facts and circumstances surrounding the formation and funding of the partnerships, on the preponderance of the evidence we conclude that Ms. Jorgensen did not have a legitimate and significant nontax reason for transferring her assets to JMA-I and JMA-II, and therefore these were not bona fide sales." The court noted that since Ms. Jorgensen used partnership funds to pay personal expenses and make gift to family members she had in actuality retained the use, benefit, and enjoyment of the assets she transferred to the partnerships. As a result, the court found that "section 2036(a)(1) includes in the value of the gross estate the values of the assets Ms. Jorgensen transferred to JMA-I and JMA-II."

The decedent's children and grandchildren filed protective claims for refund for the years 2003 through 2006 for overpaid income taxes as a result of using the decedent's original cost basis in calculating the gain on sale of assets rather than the stepped-up basis allowed as a consequence of the Court's decision. The IRS rejected the 2003 claims as untimely. However, the court allowed the estate equitable recoupment of the 2003 taxes stating that "[i]t would be inequitable for the assets to be included in the value of Ms. Jorgensen's gross estate under section 2036 on the one hand, and on the other hand for the estate not to recoup the income taxes her children and grandchildren overpaid on their sale of those very same assets but are unable to recover in a refund suit."

Source:
Westlaw: Estate of Jorgensen v. C.I.R., T.C., No. 21936-06, T.C. Memo. 2009-66, 3/26/09, 2009 WL 792071; United States Tax Court, Estate of Jorgensen v. C.I.R., T.C., No. 21936-06, T.C. Memo. 2009-66, 3/26/09.

Court of Appeals Affirms District Court's Discount for Estate's Art Collection

Last month in an unpublished opinion, the U.S. Court of Appeals for the Ninth Circuit affirmed a district court's decision that the Estate of Lois Stone (Stone v. United States, 9th Cir., No. 07-17068, 3/24/09) was entitled to claim a 5% fractional-interest discount when valuing its undivided 50% interest in a nineteen-painting art collection, rather than the larger discount sought by the estate.

Initially the government contended that no discount should apply when valuing the decedent's fractional interest whereas the estate sought a 44% discount (subsequently lowered to 36% after supplemental briefing) as proposed by its appraiser. Although the district court acknowledged that some discount was appropriate, it concluded that the Estate's request for the larger discount was not supported by the evidence, and determined a 5% discount appropriate, which was conceded to by the government. According to the lower court, "Treas. Reg. § 20.2031-1(b) requires the government to value a fractional interest at the price on which a hypothetical willing buyer and willing seller would agree, and this may often reflect a discount based on fractional ownership… But the taxpayer still bears the burden of proof. In this case, the court simply concluded that the evidence offered by the Estate was neither probative nor convincing." The court noted the appraiser's lack of experience with the art market and dissimilar motives driving purchasers to acquire art, on one hand, and real estate or limited partnership shares, on the other.

At appeal, the estate argued that district court's refusal to accept the appraiser's real estate and limited-partnership data "treated the lack of . . . data [regarding real world sales of fractional interests in art] as a barrier to valuation" and that the district court applied the "unity of ownership" principle, assuming "that the interest held by the [E]state [would] ultimately be sold [together] with the other undivided interest" in violation of Propstra v. United States (680 F.2d 1248, 1251 (9th Cir. 1982)). The Court of Appeals disagreed, affirming the lower court's previous decision.

Source:
Westlaw: Stone ex rel. Stone Trust Agreement v. U.S. 9th Cir., No. 07-17068, 3/24/09, 2009 WL 766497; United States Court of Appeals for the Ninth Circuit: Stone v. United States, 9th Cir., No. 07-17068, 3/24/09.

Tax Court Allows Full Marital Deduction Concluding Estate Taxes Allocable to Property in Decedent's Estate

Last month the U.S. Tax Court concluded in the Estate of McCoy v. Commissioner (T.C., No. 5521-07, T.C. Memo. 2009-61, 3/19/09) that Utah's equitable apportionment statute applied to the taxation of decedent's estate. As a result, estate taxes were property allocated to property included in decedent's taxable estate and not to property that would have otherwise passed to the surviving spouse thus reducing the marital deduction pursuant to I.R.C. § 2056(b)(4)(A).

In November 2002, John David McCoy died leaving a will and revocable living trust agreement, both of which were dated May 25, 1994. After decedent's death, decedent's spouse learned that he had amended and restated the original trust agreement in December 1999. Although the original trust agreement provided that if the decedent was survived by his spouse, payment of estate taxes and other debts and expenses were to be charged to the nonmarital share of the trust, the restated agreement specified that residue was to be source of payment of estate taxes but did not specify how taxes were to be apportioned between beneficiaries of residue or clearly define "residue."

In August 2003, the estate filed Form 706 claiming a marital deduction of $3,933,725, which was reported as the value of all of the assets of the gross estate except those assets specifically passing to beneficiaries other than the surviving spouse. In calculating the estate tax, the preparer charged the specific bequest beneficiaries using equitable apportionment, thus reducing their shares for estate taxes before the shares were distributed. After audit in 2006, the IRS issued the estate a statutory notice of deficiency for $412,330 based upon its determination that the estate's marital deduction should be reduced by $837,399 to $3,096,326. The Service claimed that the estate taxes should have been paid out of the residue referred to in a provision of the restated trust agreement which provided for distributions of income and principal solely for the benefit of surviving spouse. Thus, the estate improperly failed to reduce the value of the property passing to the surviving spouse by the amount of estate taxes imposed on the estate.

After analysis, however, the court concluded that "[b]ecause the restated trust agreement does not specify how the estate taxes should be apportioned and does not specify which residue those taxes should be paid from, we find that equitable apportionment applies."

Source:
Westlaw: Estate of McCoy v. Commissioner, T.C., No. 5521-07, T.C. Memo. 2009-61, 3/19/09; United States Tax Court: Estate of McCoy v. Commissioner, T.C., No. 5521-07, T.C. Memo. 2009-61, 3/19/09

Guidance Issued by IRS Attempts to Ease Burden on Victims of Ponzi Schemes

Last month the IRS issued Rev. Rul. 2009-9 and Rev. Proc. 2009-20 specifically addressing taxpayers' investment losses from criminally fraudulent investment arrangements taking the form of the "Ponzi" scheme, in an attempt to provide financial relief to investors. In Rev. Rul. 2009-9, the Service provides guidance on the income tax treatment by taxpayers of such losses. In Rev. Proc. 2009-20, the Service outlines an optional safe harbor method for eligible taxpayers to deduct such losses.

Rev. Rul. 2009-9 provides the following guidance on tax treatment for these types of losses:

• A loss from criminal fraud or embezzlement in a transaction that is entered into for profit is deemed a theft loss under I.R.C. § 165, not a capital loss.
• Investment theft losses are deductible under I.R.C. § 165(c)(2) and are not subject to either the personal loss limits in I.R.C. § 165(h) or the limits on itemized deductions in I.R.C. §§ 67 and 68.
• Investment theft losses are deductible in the year the loss is discovered, provided it is not covered by a claim for reimbursement or other recovery that the investor can reasonably expect to recover.
• The amount of the theft loss is usually the original amount invested, plus any additional investments and any income reported on taxpayer's income tax return and subsequently reinvested in the arrangement, less any amounts withdrawn and reimbursements, other recoveries, and claims that the investor has a reasonable chance of recovering.
• The theft loss can create or increase a net operating loss under I.R.C. § 172, which the taxpayer can carry back 3 years and forward 20 years. A 3, 4, or 5-year net operating loss carryback may be elected by an eligible small business for an applicable 2008 net operating loss.
• A theft loss does not qualify for the computation of tax provided by I.R.C. § 1341 for the restoration of an amount held under a claim of right.
• A theft loss does not qualify for the application of I.R.C. §§ 1311-1314 to adjust tax liability in years that are otherwise barred by the period of limitations on filing a claim for refund under I.R.C. § 6511.

Rev. Proc. 2009-20 provides that if a qualified investor follows the guidance outlined in the revenue procedure for safe harbor treatment, the investor may deduct 95% of his or her qualified investment in the "discovery year" as defined in the revenue procedure provided the investor does not pursue any potential third party recovery. If the investor is pursuing or intends to pursue recovery, a 75% deduction is available. Any deduction, however, must be reduced by amounts actually recovered and/or any potential insurance or SIPC recovery. The Rev. Proc. also details how the IRS will treat a return that claims a deduction for such a loss and does not use the prescribed safe harbor treatment.

Source:
Westlaw: Rev. Rul. 2009-9, 2009-14 I.R.B. 735, 2009 WL 678990, released March 17, 2009, Rev. Proc. 2009-20, 2009-14 I.R.B. 749, 2009 WL 678785, released March 17, 2009; Internal Revenue Service: Rev. Rul. 2009-9, 2009-14 I.R.B. 735, released March 17, 2009, Rev. Proc. 2009-20, 2009-14 I.R.B. 749, released March 17, 2009

Applicable Federal Rates for April 2009 (Rev. Rul. 2009-10)

TABLE 1
Applicable Federal Rates (AFR) for April 2009
Period for Compounding

TABLE 2
Adjusted AFR for April 2009 for purposes of I.R.C. § 1288
Period for Compounding

TABLE 3
Rates under I.R.C. § 382 for April 2009

TABLE 4
Appropriate Percentages under I.R.C. § 42(b)(2) for April 2009

Note: Under Section 42(b)(2), the applicable percentage for non-federally subsidized new buildings placed in service after July 30, 2008, and before December 31, 2013, shall not be less than 9%.

TABLE 5
Rate under I.R.C. § 7520 for April 2009

Source:
Westlaw: Federal Rates; Adjusted Federal Rates; Adjusted Federal Long-term Rate and the Long-term Exempt Rate, Rev. Rul. 2009-10, 2009-14 I.R.B. 738, 2009 WL 692045; Internal Revenue Service: Rev. Rul. 2009-10, Index of Applicable Federal Rates (AFR) Rulings, released March 18, 2009.

See all articles in current issue