At the 58th Annual Heckerling Institute on Estate Planning in Orlando this week, John W. Porter of Baker Botts L.L.P presented current issues in estate and gift tax audits and litigation and emphasized two key themes throughout: (1) preparation for a transfer tax audit or dispute should begin at the estate planning level and (2) a good appraisal can be key to a taxpayer’s success against the IRS. At the estate planning level, advisors should think about how each document will look to an IRS agent, an appeals officer, judge or similar in tax litigation. For example, when writing letters or internal memoranda, all relevant reasons for the transaction, and not just the potential estate and gift tax savings, should be noted. A “good” appraisal is generally one by a qualified appraiser.
Given the varied results in case law related to hard-to-value assets like closely held entities, value adjustment formula clauses can be used to remove valuation uncertainty from transactions. Porter detailed the various types of formula clauses, namely (1) defined value clauses based on values “as finally determined for estate/gift tax purposes,” as seen in Estate of Christiansen v. Commissioner, Estate of Petter v. Commissioner, and Estate of Wandry v. Commissioner, (2) defined value clauses, as seen in Succession of McCord v. Commissioner and Hendrix v. Commissioner; and price adjustment clauses, as seen in King v. United States. Importantly, reversion clauses will not be successful pursuant to the holding in Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944). Porter noted that where a formula clause is used, the instrument should include a description of how to reallocate shares if it is determined that the shares are of a greater or lesser value than the appraised value.
For a formula clause to be successful, the amount in excess of the defined value must pass to a person or entity that will not result in the imposition of transfer taxes. McCord, Hendrix, Petter and Christiansen all involved transfers of the excess amount to charity. Clients who are not charitably inclined can look to Wandry, which involved the transfer of a specified dollar amount of assets, with any “overage” being retained by the transferor, or can consider QTIP trusts and GRATs as recipients of the nontaxable portion of the transfer.
Porter then turned to areas in which the IRS is focused on, including QTIP terminations that involve a surviving spouse and installment sales. Porter focused on the following areas:
- Adequate Disclosure for Statute of Limitations. I.R.C. § 6501(a) provides that a three-year statute of limitations generally applies from the date a gift tax return is filed for the IRS to assess gift tax, but the statute does not start running without “adequate disclosure.” Cases can therefore arise at a taxpayer’s death on gift taxes filed years ago but which the IRS says adequate disclosure was not satisfied. Fortunately, the Tax Court’s recent decision in Schlapfer v. Commissioner provided guidance that adequate disclosure requires substantial compliance rather than strict compliance with the adequate disclosure rules.
- Promissory Notes. The IRS sometimes takes the position that loans at the AFR rate can be valued at less than face value for gift tax purposes. I.R.C. § 7872 applies to loans that charge below-market interest rates, the consequence of which is the recharacterization of the transaction as one in which the amount of interest needed for the loan to charge market interest is gifted from the lender to the borrower and then retransferred by the borrower to the lender as interest. Porter explained that if the IRS takes such a position, responses can include citation of PLR 9535026, in which the Commissioner acknowledged that a note bearing interest at the applicable Federal rate does not result in a gift subject to gift tax, and of the proposed regulations for § 7872, which provide a safe harbor for notes bearing interest at the applicable Federal rate. Outside of the interest rate context, courts will respect an intra-family loan as debt if the parties intended the loan to be a debt, and the parties had a reasonable expectation of repayment. The IRS will review the administration of the loan in such a dispute, including whether records reflect the debt evidence by the loan, or if actual repayments were made. It is important that interest be paid, and timely.
- GRATs. The IRS has increasingly audited GRAT transactions with three principle focuses: (1) whether the terms of the GRAT comply with the § 2702 regulations; (2) whether the GRAT has been operated in accordance with its terms; and (3) valuation issues. Porter again noted the importance of a good valuation, particularly where hard to value assets are used to pay the annuity, and of proper administration of the GRAT. The IRS will seek to substantiate annuity all payments and, if not timely made, could argue that the retained annuity is non-qualified interest under an analysis based on Estate of Atkinson v. Commissioner.
- I.R.C. § 2036(a). Ported noted that I.R.C. § 2036(a) is the most litigated area, and the IRS has use it to challenge family limited partnerships where the taxpayers failed to respect the integrity of the entity. Where the IRS is successful, the assets of the partnership are brought back into the decedent’s estate as a retained life interest, even where the asset was transferred during life, and sometimes resulting in a marital or charitable deduction being inapplicable. Porter discussed several ways to avoid this result, including satisfying the bona fide sale test, or creating two classes of interests (with and without vote on dissolution/amendment). He also noted that considering the IRS’s particular interest in I.R.C. § 2036(a)(2), caution should be used where a family member is acting as general partner, and that individual should not have unfettered discretion with regard to distributions from an entity. He suggested use of a “best business judgment” or similar standard where a family member must be in that role.
Porter concluded his remarks by noting that the IRS has increasingly attempted to impose valuation penalties in transfer tax audits for valuation understatements pursuant to I.R.C. § 6662(g) and (h) which impose penalties of 20 to 40 percent. §6664(c) provides a reasonable cause exception where the taxpayer acted in good faith and with reasonable cause in reporting the value of transferred assets.
Given the increase in audits by the IRS and its interest in applying penalties, Porter’s advice to plan for an audit at the estate planning level and to secure a good appraisal should be heeded.
Sarah M. Roscioli is an associate at ArentFox Schiff, LLP, in Chicago.