Estate Tax Update
As of December 20, Congress has not passed a bill to "fix" the estate tax for 2010. Earlier in the month, the House of Representatives, on a party-line vote, passed a bill to make 2009’s $3.5 million estate tax exemption amount and 45% tax rate permanent. The Senate has taken no action on the bill, however. At this time, it appears most likely that Congress either will temporarily extend the current estate tax regime until they can pass a major tax reform bill in 2010 or they will take no action in 2009 and work on the tax bill in 2010. Any eventual estate tax legislation could be made retroactive to January 1, 2010. Uncertainty always creates planning opportunities. Clients should not delay implementing their estate plan until Congress determines what revenue enhancements (tax increases) will be enacted to pay for the health care and economic stimulus proposals that currently are under consideration.
Major Taxpayer Victory!
On November 13, 2009, the Eighth Circuit Court of Appeals affirmed the Tax Court’s approval of a formula clause planning strategy in Estate of Christiansen, 104 AFTR.2d ¶ 1009-5595 (8th Cir. 2009), aff'g, 130 T.C. 1 (2008). This landmark decision involves a strategy sometimes referred to as a "charitable lid" estate planning strategy. The charitable lid strategy leaves a set dollar amount of the probate or trust estate to noncharitable beneficiaries, with the residuary probate or trust estate passing to a charitable beneficiary.
The residual portion passing to the charitable organization qualifies for the estate tax charitable deduction under Internal Revenue Code § 2055, thereby putting a "lid" on the net amount that is included in the decedent’s taxable estate. The presence of the "lid" creates a disincentive for the IRS to increase the value of assets as shown on the decedent’s estate tax return, as any increase in the value of those assets would be offset by a corresponding increase in the estate tax charitable deduction. The Court of Appeals and Tax Court upheld the planning strategy despite attacks by the IRS on public policy grounds.
Helen Christiansen left her entire estate to her daughter. Her Will provided that should her daughter disclaim any or all of her interest in Helen’s estate, such disclaimed property would pass seventy-five percent to a "zeroed-out" testamentary charitable lead annuity trust (TCLAT) and twenty-five percent to Helen’s private foundation.
The daughter executed a timely formula disclaimer of a portion of her interest in her mother's estate. The disclaimed property was a fraction of the daughter’s inheritance, the numerator of which was the difference between the value of the estate and $6.35 million, and the denominator of which was the value of the entire estate. Importantly, "value" was defined as the fair market value "as finally determined for federal estate tax purposes." The formula disclaimer capped the amount passing to the daughter at $6.35 million, with the assets of the estate in excess of $6.35 million passing to the TCLAT and the private foundation.
The estate valued its assets at approximately $6.5 million. This included a 35% minority interest valuation discount on partnership interests held by the estate. Based on this value, $121,667 would pass to the TCLAT and $40,555 would pass to the foundation as the result of the disclaimer.
The estate took a charitable deduction for the amount passing to the foundation and for the present value of the annuity amount payable to the foundation. Upon auditing the estate tax return, the IRS determined that the fair market value of the limited partnership interests should be increased. The estate asserted, however, that the effect of the increase in value would only result in an increase in the amount of property passing to the foundation and the TCLAT, so that the increase in value of the estate should be fully offset by an estate tax charitable deduction. Therefore, the changes made by the IRS on audit would not result in any additional estate tax.
The IRS successfully challenged the charitable deduction for the property passing to the TCLAT because the disclaimer by the daughter did not disclaim her remainder interest in the TCLAT. Therefore, it was not a qualified disclaimer under IRC § 2518. The IRS relied on an example in the regulations stating that "if a disclaimant who is not a surviving spouse receives a specific bequest of a fee simple interest in property and as a result of the disclaimer of the entire interest, the property passes to a trust in which the disclaimant has a remainder interest, then the disclaimer will not be a qualified disclaimer unless the remainder interest in the property is also disclaimed." Because the daughter did not disclaim the remainder interest in the TCLAT and the nine month period to do so had already elapsed, the formula disclaimer to the TCLAT was invalid.
The IRS alleged that the formula clause disclaimer to the private foundation was also void, because it violated public policy. The IRS contended that allowing the use of formula clauses of this type would lead to abuse because the IRS could collect no additional revenue even if it determined estate assets were undervalued. In making this argument, it relied on the holding in Proctor v. Commissioner, 142 F.2d 824 (4th Cir. 1944). The Eighth Circuit held that the use of a formula clause of this type should not lead to rampant valuation abuses. The executor of the estate or trustee of the trust has a fiduciary duty to all beneficiaries as well as the IRS to accurately value the assets and the charity has an interest in assuring the property is accurately valued in order to maximize its interest in the property.
