Tax Law Update

Disclaimed assets pass to grandchildren, not trust. Luckily for the beneficiaries involved, the U.S. District Court for the Western District of Pennsylvania in Offner v. United States, 2008 WL 398823 (W.D. Pa. Feb. 11, 2008) was not forced to engage in subtle distinctions about what qualifies for a charitable deduction. During Deanie Offner's life, she established an irrevocable trust for the maintenance,

Disclaimed assets pass to grandchildren, not trust. Luckily for the beneficiaries involved, the U.S. District Court for the Western District of Pennsylvania in Offner v. United States, 2008 WL 398823 (W.D. Pa. Feb. 11, 2008) was not forced to engage in subtle distinctions about what qualifies for a charitable deduction.

During Deanie Offner's life, she established an irrevocable trust for the maintenance, health, support and education of her grandchildren. Under Deanie's will, her children received general legacies, and if any child predeceased her, the child's legacies would pass to that child's descendants. The trust was to receive the residue of the estate.

Within nine months of Deanie's death, two of her children disclaimed a portion of their legacies. The estate claimed a charitable deduction under IRC Section 2055 for the disclaimed amount passing to the trust on the theory that the trust served charitable purposes (the grandchildren's education.)

That's a creative, but not likely a successful argument. Good thing the district court did not have to consider it. The court held that because the disclaimers were valid, Deanie's children were treated as predeceased as to the portion that had been disclaimed. Therefore, the disclaimed portion would be distributed directly to the disclaimant's children, not to the trust.

Of course, if the property had passed to the trust, it's unclear how a charitable deduction could have been justified. A trust for the benefit of a person's grandchildren clearly serves a private purpose — however, much the public might eventually benefit from these educated offspring.

  • Loans to a family-owned business are not QFOB interests

    In Estate of Farnam v. Commissioner, 130 T.C. No. 2 (Feb. 4, 2008), Duane and Lois Farnam owned interests in a family business organized as a Minnesota corporation, which operated stores that sold automobile parts. Duane and Lois, along with other members of their family, managed this business. Every year since 1981, Duane and Lois and other members of the family made loans to the business, which issued promissory notes in return. Not only were these notes unsecured, but also they were subordinate to claims of outside creditors. Later, in 1995, Duane and Lois each formed a limited partnership (LP) to which each contributed real estate and several of the notes.

When Duane died in 2001, he owned 50 percent of the outstanding shares of the company's voting common stock and 99 percent of his LP. When Lois died in 2003, she owned 50 percent of the outstanding shares of the company's voting common stock, and 92.72 percent of her LP. The common stock in the company and the promissory notes owned at their deaths individually and through the LPs were included in their respective gross estates. Both estates claimed qualified family-owned business interest (QFOBI) deductions under Internal Revenue Code Section 2057 and included the promissory notes as part of the QFOBI for the purposes of the 50 percent liquidity test of IRC Section 2057(b)(1)(C).

The Internal Revenue Service issued statutory notices determining estate tax deficiencies and disallowed the QFOBI deductions.

IRC Section 2057 allows an estate to deduct from the value of the gross estate the adjusted value of QFOBIs, up to $675,000 — if the value of the QFOBIs owned by a decedent at death exceed 50 percent of the total value of the decedent's adjusted gross estate (the 50 percent liquidity test.) Under IRC 2057(e)(1)(B)(i), an interest in an entity carrying on a trade or business in which at least 50 percent of such entity is owned by the decedent and members of the decedent's family is a QFOBI.

The estate argued that QFOBIs include both equity ownership interests and loan interests.

The Tax Court disagreed. It relied on the close proximity of the term “interest in an entity” to specific references to equity interests within IRC Section 2057. It highlighted IRC Section 2057(e)(3)(A), which, in explaining how to calculate family ownership, expressly refers to “equity interests,” “stock,” “capital” and “ownership interests;” IRC 2057(e)(1)(A) limits a sole proprietor's QFOBI to that of his “interest as a proprietor.” The court reasoned that, because of the pervasive language connoting equity ownership in IRC Section 2057, an interest in an entity, for the purposes of the QFOBI deduction, is limited to equity ownership interests. As a result, the court found that a loan does not qualify under IRC Section 2057(b)(1)(C) for the 50 percent liquidity test.

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