LEGISLATIVE UPDATE

Tax Court Rules on Marital Deduction, Valuation Discounts on Transfers to FLP

Last month, the U.S. Tax Court concluded in the Estate of Miller v. Commissioner (T.C., No. 5207-07, T.C. Memo. 2009-119, 5/27/09) that the amounts for which the decedent Valeria Miller's late husband's estate had claimed a marital deduction are properly includible in Mrs. Miller's gross estate. The court also determined that a valuation discount for assets transferred to decedent's family limited partnership in April 2002 were permissible, but denied a valuation discount on assets transferred to the partnership in May 2003, shortly before her death.

Decedent's husband, Virgil J. Miller, died on February 2, 2000. At the time of his death, Mr. Miller's gross estate was valued at $7,667,939, with $7,635,755 representing securities held by his revocable living trust. Provisions in the trust agreement established a life estate marital trust for decedent (the QTIP trust). Mr. Miller's executor timely filed the federal estate tax return with the Internal Revenue Service, electing to treat the QTIP trust property as qualified terminable interest property pursuant to I.R.C. § 2056(b)(7) and claiming a marital deduction of $1,060,000 for assets funding the QTIP trust. The remaining assets in Mr. Miller's revocable trust were distributed to his wife's revocable living trust. The QTIP trust provided that all income of the QTIP trust was to be distributed to decedent at least annually. However, no distributions were made and all income from the QTIP trust was reported on its own Form 1041 each year.

In 2001, Mrs. Miller formed the V/V Miller Family Limited Partnership (MFLP), which was signed in March 2002 and funded in May 2002 with securities representing about 77 percent of her assets. The MFLP issued 1,000 units with her trust owning 920 units, and Mrs. Miller gifting 10 general partner and 10 limited partner units to one son and 20 units to each of her other three children. Mrs. Miller's son, as general partner, managed the securities portfolio using the charting method developed by his father.

In May 2003, while recovering from a broken hip resulting from a fall, Mrs. Miller was diagnosed with congestive heart failure and discovered to have a traumatic brain injury. Just prior to her death on May 28, 2003, most of the securities in her brokerage accounts were transferred to MFLP.

In February 2004, decedent's estate filed a federal estate tax return reporting a gross estate of $2,637,024, which included the 920 MFLP units valued at $2,589,118 after application of a 35 percent discount, and tax due of $994,299. The return showed that decedent was the beneficiary of a trust for which a deduction had been claimed by the estate of decedent's spouse under I.R.C. § 2056(b)(7), but did not include in decedent's gross estate the values of the securities used to fund the QTIP trust. Upon review, the IRS issued a notice of deficiency of $1,019,399 resulting from an increase in the value of decedent's gross estate for the value of the securities in the QTIP trust and the full fair market value of decedent's transfers to MFLP.

The estate argued that the value of the assets in the QTIP trust was not taxable in Mrs. Miller's estate because she "never received income or distributions from the trust, was never considered to have an interest in the trust, and to the extent she had an interest in the trust, effectively refuted it before her death." The IRS argued that since a QTIP election was made by her late husband's estate and a deduction allowed under I.R.C. § 2056(b)(7), and since decedent had the right to receive income from the trust annually and did not dispose of her income interest in the trust before she died, her estate was required to include the those assets. The court agreed with the IRS.

With regard to decedent's contributions to MFLP, the estate claimed the transfers were bona fide sales for adequate and full consideration and that there were "legitimate and substantial nontax business reasons for the creation of MFLP, including asset protection, succession of management, centralized management, and continuation of the family's investment strategy." Citing several factors as evidence, the IRS, however, contended that the transfers were did not constitute a bona fide sale for adequate and full consideration and therefore were not exempt from the application of I.R.C. § 2036(a).

The court agreed with the estate in valuing the April 2002 transfers, determining that Mrs. Miller had legitimate nontax business reasons for establishing MFLP and contributing the securities "to ensure that her assets continued to be managed according to Mr. Miller's investment philosophy." Thus the transfers "satisfy the bona fide sale for adequate and full consideration exception and are not governed by section 2036." However, the court did not permit the valuation discounts for the May 2003 contributions to MFLP, noting that the transfers were simply a tax avoidance device with "no significant nontax purpose."

Source:
Westlaw: Estate of Miller v. Commissioner, T.C., No. 5207-07, T.C. Memo. 2009-119, 5/27/09, 2009 WL 1472208; United States Tax Court, Estate of Valeria M. Miller v. C.I.R., T.C., No. 5207-07, T.C. Memo. 2009-119, 5/27/09

Court Denies Government's Motion for Summary Judgment in Calculation of Marital Deduction

In Alan Baer Revocable Trust dated February 9, 1996 v. United States (D. Neb., No. 8:06CV774, 5/18/09, 2009 WL 1451577), the U.S. District Court rejected the government's motion for summary judgment when the decedent's estate challenged the IRS's reduction of the claimed marital deduction and valuation of a start-up, private corporation with no earnings. The court concluded that evidence presented by the estate created an issue of material fact with respect to the date-of-death value of the corporation's stock which must be resolved.

Alan Baer died on November 5, 2002. At the time of his death, he owned ComoreTel, Ltd., through his 99% ownership interests in two limited partnerships that owned the company. ComoreTel's stock was not publicly traded. Decedent's revocable trust provided for specific bequests of money to twenty-three beneficiaries totaling $1,346,000 that were contingent upon the eventual sale of decedent's interest in ComoreTel and realization of a profit. The remainder of the estate was to be distributed to a residual trust for the benefit of decedent's surviving spouse with trust income paid to her at least quarterly and discretionary payments of principal. The estate's federal estate tax return reported a gross estate value of $61,898,237.63, claiming that $61,440,434 passed directly to the surviving spouse as part of the marital deduction and noting that "upon the best information available to the Personal Representative at the time of filing this return, these contingent bequests may never be paid out; but if they do get paid, it will be approximately six years before the bequests are complete."

Upon audit, the IRS adjusted the return "to reflect the aggregate value of property interests passing from the decedent to the surviving spouse, allowable as the estate tax marital deduction", decreasing the allowable marital deduction and increasing the taxable estate by $1,942,790, resulting in a total estate tax liability of $824,139. The estate paid the tax and filed a claim for refund of $578,984 plus interest, arguing that "the assumption that the contingent beneficiaries would receive $1,346,000 was premised on a speculative valuation of ComoreTel as worth $51,400,000 at the date of Alan Baer's death" when considering the company was a startup corporation with no earnings and that a 2006 appraisal reported ComoreTel's total value at $3,000,000, and the decedent's shares at $851,114.

The IRS argued in its motion for summary judgment that the decedent's trust provided "a possibility the bequests will be funded and paid to beneficiaries other than Baer's surviving spouse," and therefore cannot be claimed in the marital deduction but must be part of the decedent's taxable estate. It claimed that the underlying value of the stock was irrelevant and that the proper inquiry was whether the contingent bequests qualify for the marital deduction. The estate agreed that the contingent beneficiaries could not be included in the marital deduction but countered that the issue was "the value, if any, in ComoreTel Holdings Ltd. ("ComoreTel"), which comprises the basis for whether the contingent bequests lapsed under Neb. Rev. Stat. § 30-2345." It argued that there is essentially "no value to the bequests at issue and that the value attributed to the bequests is a 'phantom value' because the contingency—that ComoreTel stock is sold and a profit realized—cannot be fulfilled and the bequests cannot vest."

In its decision, the court stated that "[t]he government's contention that value is irrelevant is misplaced," and found that evidence presented by the estate supported its contention that the date-of-death value of the ComoreTel stock on which the deficiency determination relied was speculative and overstated. The court agreed that the issue is the value of ComoreTel's stock, which is "relevant to the marital deduction if the Baer estate can show that at the date of Alan Baer's death, the contingency on which the bequests depended—sale of the ComoreTel stock at a profit during the surviving spouse's lifetime—would never occur, so as to extinguish the contingent bequests." Thus the government's motion for summary judgment was denied.

Source:
Westlaw: Alan Baer Revocable Trust Dated February 9, 1996 v. U.S., D. Neb., No. 8:06CV774, 5/18/09, 2009 WL 1451577; U.S. District Court – Nebraska: Alan Baer Revocable Trust Dated February 9, 1996 v. U.S., D. Neb., No. 8:06CV774, 5/18/09. (Information about this case is available on the U.S. Court's PACER system. A subscription to PACER is required.)

IRS Issues Guidance on Tax Treatment for Buyers and Sellers of Life Insurance Contracts

In May, the Internal Revenue Service issued two revenue rulings addressing the tax consequences to individuals who either sell or surrender life insurance contracts and to investors who buy those contracts.

Rev. Rul. 2009-13 provides guidance on the amount and character of an individual's income that must be recognized upon the surrender or sale of a life insurance contract as described in three different situations involving a policyholder who is also the insured.

In the first example, the owner-insured surrenders the contract in year 8 for its $78,000 cash surrender value, an amount net $10,000 "cost-of-insurance" charges. Premiums paid by the owner during the life of the contract totaled $64,000; neither distributions nor loans against the contract's cash surrender value had been made. At the time of surrender the owner-insured was not terminally or chronically ill within the meaning of I.R.C. § 101(g)(4). In its analysis, the IRS pointed out that the surrender of a life insurance contract does not produce a capital gain and stated that "[u]nder section 61(a)(10) of the Code, the proceeds received by an insured upon the surrender of, or at maturity of, a life insurance policy constitutes ordinary income to the extent such proceeds exceed the cost of the policy." Thus $14,000 of ordinary income should be recognized by the taxpayer on surrender of the contract.

In the second example, the facts are the same as in Example 1, except that the owner-insured sells the life insurance contract in year 8 for $80,000 to an unrelated person. The IRS noted that in the case of a sale, I.R.C. § 61(a)(3) provides that gross income includes gains derived from dealings in property with I.R.C § 1001(a) providing that the gain to be realized is the excess of the amount realized over the adjusted basis provided under I.R.C. § 1011. The taxpayer's adjusted basis in the property is $54,000, determined by subtracting the $10,000 cost-of-insurance charges from the $64,000 premiums paid resulting in a gain of $26,000. According to the ruling, $14,000 (the difference between the policy's $78,000 cash surrender value and the $64,000 premiums paid) is taxed as ordinary income, with the remaining $12,000 of the gain taxed as long-term capital gain.

In the third example, the facts are the same as in Example 1, except that the contract was a level $500 per month premium/15-year term life insurance contract with no cash surrender value. Premiums paid totaled $45,000. In this example, the policy holder sells the contract in year 8 for $20,000 to an unrelated person. The IRS said that absent other proof, with a term policy the cost of insurance is presumed to equal the monthly premium under the contract (in this case $500). Since the contract was held for 89.5 months, the taxpayer's adjusted basis in the contract on date of sale is $250 ($45,000 total premiums paid less $44,750 cost-of-insurance) resulting in a long-term capital gain of $19,750 under I.R.C. § 1222(3).

Revenue Ruling 2009-14 provides guidance on the tax consequences to investors who receive death benefits or sale proceeds regarding a term life insurance contract he or she bought for profit.

In the first example, a U.S. investor purchases an in-force U.S. life contract with a $100,000 death benefit for $20,000, paying an additional $9,000 in premiums to keep the policy in force. Upon the death of the insured, the taxable amount to the seller would be $71,000, determined by subtracting the investor's adjusted basis of $29,000 ($9,000 premiums paid plus the $20,000 purchase price) from the $100,000 death benefit. According to the ruling the amount taxed is treated as ordinary income.

In the second example, the facts are the same as in Example 1, except the investor sells the policy to a second investor during the insured's lifetime for $30,000. According to the ruling, the seller would recognize $1,000 in revenue (sale price of $30,000 less adjusted basis of $29,000), which would be taxed as a long-term capital gain.

In the third example, the facts are the same as Example 1, except the investor is a foreign life settlement company buyer. In this case, the IRS stated that the buyer would have to recognize $71,000 in taxable income, just as in the first situation, and treat the income as ordinary income from sources within the United States.

Source:
Westlaw: Rev. Rul. 2009-13, 2009-21 I.R.B. 1029, May 26, 2009, 2009 WL 1163860; Rev. Rul. 2009-14, 2009-21 I.R.B. 1031, May 26, 2009, 2009 WL 1163861; Internal Revenue Service: Rev. Rul. 2009-13, 2009-21 I.R.B. 1029, May 26, 2009, Rev. Rul. 2009-14, 2009-21 I.R.B. 1031, May 26, 2009.

Internal Revenue Service Tax Talk Today Program Focuses on Estate, Gift, and Employment Tax

Last month, the Internal Revenue Service presented a 100-minute program titled "Specialty Taxes: Estate and Gift and Employment Taxes", which covered several estate and gift tax topics as well as employment tax issues that the IRS felt may impact a large number of taxpayers. "Tax Talk Today" is a series of free, live, interactive webcasts aimed at professionals that provide participants with the opportunity to interact directly with IRS representatives and practicing professionals on current tax issues while earning continuing education credits.

Panelists for May's program from the IRS were James F. Hogan, senior technician reviewer, estate and gift tax, passthroughs and special industries, office of chief counsel; Lisa M. Piehl, policy manager, estate and gift tax, small business and self-employed division; Mary Gorman, assistant division counsel, pre-filing, small business self-employed division; and Joseph Tiberio, program manager, employment tax policy, small business self-employment division. Also on the panel were Daniel T. Moore, CPA, senior accountant and chief financial officer, Moore Agency Inc., Salem, Ohio and Kathy Harrison-Suits, enrolled agent and vice president of Summit Capital Advisors, Tacoma, Washington.

Topics covered during the estate and gift tax segment of the program included:

• filing thresholds and other requirements for filing estate and gift tax returns.
• due dates and extensions for filing estate and gift tax returns and payment of any tax due.
• practical tips for gathering information needed to file returns.
• information and supporting documents that should be provided in order for the IRS to consider the return complete.
• exclusions and deductions allowable on the return and common problems that the IRS sees in this area.
• valuation of assets.
• generation skipping transfer tax.
• options for estates that include small, closely-held businesses and family farms that, as a result, have insufficient liquid assets to pay estate taxes.
• Organization of the IRS estate and gift program and methods the IRS uses to identify non-filers.

The last part of the program addressed employment tax issues, including:

• the subsidized Consolidated Omnibus Budget Reconciliation Act (COBRA) premium created by the American Recovery and Reinvestment Act of 2009 and its affect on employers and individuals.
• the National Research Project for employment taxes.
• various reporting issues with Form 941, Employer's Quarterly Federal Tax Return.

The transcript of the webcast is available on the Tax Talk Today website at www.taxtalktoday.com. Subscribers can also view live webcasts and archived programs; listen to audio podcasts, and order audio and video recordings. The IRS is looking at hosting two additional "Tax Talk Today" shows this fiscal year. More information is available on Tax Talk Today's website.

Source:
Internal Revenue Service: May Tax Talk Today Show Covered Current Estate, Gift and Employment Tax Issues, Headliner Volume 266, published May 29, 2009.

Applicable Federal Rates for June 2009 (Rev. Rul. 2009-16)
TABLE 1
Applicable Federal Rates (AFR) for June 2009 for purposes of I.R.C. § 1274(d)
Period for Compounding

TABLE 2
Adjusted AFR for June 2009 for purposes of I.R.C. § 1288(b)
Period for Compounding

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

TABLE 4
Appropriate Percentages under I.R.C. § 42(b)(1) for June 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 June 2009

Source:
Westlaw: Federal Rates; Adjusted Federal Rates; Adjusted Federal Long-term Rate and the Long-term Exempt Rate, Rev. Rul. 2009-16, 2009 WL 1395465; Internal Revenue Service: Rev. Rul. 2009- 16, Index of Applicable Federal Rates (AFR) Rulings, May 29, 2009.

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