This post was originally published on Forbes Sep 25, 2015
The Tax Court decision in the case of Jean Steinberg is a great example of planners taking a rule that is meant to prevent taxpayers from getting away with something and using it to, well, get away with something. The stakes were pretty high – $1,804,908 in gift tax for the year 2007. Ms. Steinberg is the widow of Meyer Steinberg, philanthropist and reals estate developer, who founded Enterprise Asset Managment. Ms. Steinberg gave her daughters over $109 million worth of real estate so perhaps the part of the gift tax at stake doesn’t sound quite as high anymore. The gift was a “net gift” meaning that her daughters were required to pay the resulting gift tax, but there was more. There is something that you need to understand about the gift tax to fully appreciate what was done.
Enter at item A of Schedule G the total value of the gift taxes that were paid by the decedent or the estate on gifts made by the decedent or the decedent’s spouse within 3 years of death.
So gifts made shortly before death end up being taxed as if they were bequests.
Assuming her daughters would have inherited the property and purely considering transfer taxes, the net gift was a good idea in a kind of nothing ventured nothing gained type of thinking. Included in the estate the property would generate over $50 million in estate tax at rates in effect in 2007. Instead under the net gift the daughters received the property in exchange for paying just over $32 million in gift tax.
Of course had Ms. Steinberg died within three years, the estate would have the gift tax added and this is where the planning went from good to great. The daughters agreed that in the event that happened they would be responsible for the additional estate tax. That had the effect in the taxpayers view of further lowering the value of the gift making it not just a net gift, but a net net gift. The IRS did not agree and that was what the case was about.
Mr. Frazier testified that he used the actuarial tables promulgated by the Commissioner to calculate the probability that petitioner would die within each of the three years after the date of the net gift agreement. The report calculated petitioner’s annual mortality rate for year 1, year 2, and year 3 to be 13.84%, 13.04%, and 12.13%, respectively. The report used the section 7520 interest rate applicable on the date of the transfer to determine the present value factors for each of the three years. Then the report took the effective State and Federal estate tax rates for each of the three years and multiplied them by the gift tax included in the estate under section 2035(b). Using this methodology, the report calculated that the daughters’ assumption of the section 2035(b) estate tax liability reduced the value of the combined gift by $5,838,540.
The mortality assumptions underlying the computations in this case are on page 866 of this manual if you want to follow along. Apparently Ms. Steinberg was 89 at the time of the gift. According to the table, if you start with 100,000 people 19,783 will make it to age 89, 17,046 to 90, 14,446 to 91 and 12,066 to 92. That’s where the percentages come from. I often remark that you learn almost all the math you need to do tax returns by the fourth grade. Computations like this are an exception. Although a bright sixth grader probably could handle them with proper direction. Nonetheless, it is the actuaries who handle things like this.
The table makes me think of Ishmael visiting the Whaleman’s Chapel in New Bedford before embarking on the Pequod where he contemplates the marble tablets commemorating whalemen lost at sea. In that Table 90CM on page 866, our destiny is written. 100,000 begin at age 0 and at each succeeding age the number drops finally reaching 17 at age 109 and then 0 at age 110 (People like Jeanne Calement who celebrated her 122nd birthday are a round off error). Nobody gets out alive. Ishmael had the tablets in the Whaleman’s chapel. Hamlet had Yorick’s skull. I have Table 90CM (There is a newer table 2000CM which is bit more optimistic, but nobody gets out alive on that one either).
There is a movie about somebody who spent his career on computations of this sort.
At the time of the gifts at issue it was also not possible to determine the provisions of the donor’s will that would exist at the time of her death. As matter of law the donor is entitled to change the provisions of her will before her death. There is no certainty that her four daughters would be the beneficiaries of her will. In the past the donor had made changes to her will which at one point excluded one of the daughters as a beneficiary. At the time petitioner and her daughters signed the net gift agreement, there was no guaranty that the daughters would remain beneficiaries under petitioner’s residuary estate. Petitioner is still alive and remains free to change her will at any time. The net gift agreement guaranteed that the daughters would assume the section 2035(b) liability. This guaranty placed a burden on the daughters that they may not have had to otherwise bear.
In valuing the gift the daughters were deemed to be assuming a contingent liability. Did they have an income tax problem in 2010, when it turned out that they were out from under the contingency? I’m close to certain that they do not. Even though, the contingency suppresses the value for transfer tax purposes, it is not a liability under income tax principles.
Of course, the savings from paying gift tax rather than estate tax are anything but a free lunch. There is the time value of money, which granted was a bigger deal back in the day when money earned interest. There is also the loss of basis step-up. Of course, there can be basis step-down in some circumstances. Finally, there is that uncertainty about the future. In 2010, we had a year without an estate tax. That could happen again. Under Jeb Bush’s plan the estate tax will be eliminated. Bernie Sanders, on the other hand, wants to raise the rate to 55% on estates over $50 million with a 10% surtax for billionaires.
there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands
The net gift agreement was the result of several months of negotiation between petitioner and her daughters. Petitioner and her daughters were represented by separate counsel.
Handler said ‘‘the arrangement wasn’t a common estate planning tool, because if the client is younger, the reduction for the assumption of liability isn’t that much. If the client is older, the risk of assuming the liability may be too high.’’
Handler added that an estate planner could get a letter from a doctor attesting to a donor’s health. ‘‘If the person is in poor health, there could be a larger reduction in the gift tax, but there would also be greater risk of estate tax liability,’’ he said
Of course, a donee who is sure of being a residuary beneficiary is not really taking any risk at all. Just don’t forget that Mothers Day card.
That’s what Susan, Bonnie, Carol and Lois did when they undertook the pay their Ma’s gift tax, and the estate tax if the gifts Ma was giving them was clawed back into Ma’s estate if Ma died within the three-year clawback rule.
IRS tries to rehash their losing intrafamily gift arguments from the September 2013 case they lost, but Judge Kerrigan blew that off then, and blows it off now. Even though not made in the ordinary course of business, the deal was negotiated extensively, the parties all had independent counsel, and no one claims the deal wasn’t bona fide or arms’-length.
Best of all, The Four have an expert, and IRS has only the Michael Corleone gambit.
The Michael Corleone gambit is based upon a line in The Godfather film, where Michael is to go to a restaurant, upon entering which he will be searched for weapons. His coadjutors arrange to secrete a revolver in the restaurant’s mens’ room, so that Michael can assassinate a Police Captain. One accomplice tells the others to make sure the weapon is in its place and properly concealed. “I don’t want Michael coming out of the toilet with nothing in his hands but his d**k.” The gambit thus entitled described a party with no evidence for their position.
Thanks for the clarification. I remember the scene.