On Nov. 20, 2018, the Tax Court issued its third decision in the Estate of Turner line of cases (Estate of Turner v. Comm’r, 151 TC 10 (2018) (Turner III); Estate of Turner v. Comm’r, 138 TC 306 (2012) (Turner II); and Estate of Turner v. Comm’r, T.C. Memo. (2011-2019) (Turner I), altogether (Turner cases).
The decedent in the Turner cases, Clyde W. Turner Sr., died in 2004. In the interim 14-year period, extensive litigation has focused on the estate tax liability related to a family limited partnership created less than two years before his passing. In short, Clyde and his wife Jewell transferred approximately $8.67 million of various liquid assets, such as cash, stocks and certificates of deposits, into the FLP. In return for their contributions, they each took back a 0.5 percent general partnership interest and a 49.5 percent limited partnership interest. Within 13 months before Clyde’s death, he and Jewell each gifted a 21.7446 percent LP interest to their children. The value of the LP interest transferred was reported on a gift tax return, taking into account various valuation discounts as determined by professional appraisers. When Clyde, his GP interest and remaining LP interest were also professionally appraised and valuation discounts were applied to those interests, the Internal Revenue Service challenged this planning by claiming that the value of the underlying assets of the LP interests transferred were included in the decedent’s estate under a variety of Internal Revenue Code sections including IRC Section 2036(a)(1). The IRS argued that the bona fide sale exception didn’t apply to the transaction because Clyde had no legitimate and/or significant non-tax purpose for creating the entity.
Parts I and II of the Turner Trilogy
In Turner I, the Tax Court agreed with IRC Section 2036(a)(1) inclusion argument because Clyde: (1) received a partnership management fee to do exactly what he did prior to the formation of the partnership, (2) received disproportionate distributions from the partnership, (3) used his own funds to invest on behalf of the partnership without a repayment plan, (4) comingled personal and partnership assets, (5) used partnership assets to pay the legal fees for his own estate planning, and (6) used partnership assets to pay insurance premiums on policies in his insurance trust. The result in Turner I shouldn’t come as a surprise given the facts of the case.
Turner I established the underlying assets of the LP interests gifted were subject to estate inclusion and in turn taxation. The latter two Turner cases address the computation of the estate tax liability. In Turner II, the Tax Court was asked to address the impact of the estate tax marital deduction on the inclusion of the assets. The estate asserted that the decedent’s estate plan provided a formula clause that Jewell was to receive sufficient assets to reduce the estate tax liability to zero; therefore, the marital deduction should be increased to reduce the estate tax liability to zero. Such provisions are commonplace in estate plans. The Tax Court rightly rejected this argument as it was conflating two different concepts. The decedent’s estate plan required that sufficient assets be transferred to increase the martial deduction to make the taxable estate non-taxable (taking into account credits available). The decedent’s estate plan didn’t and couldn’t state that the marital deduction itself equals the correct number to ensure the estate had no tax liability. Under IRC Section 2056, the marital deduction only applies to assets that “pass” to the spouse. Tax sensitive estate plans that rely on formula provisions seek to pass the correct amount of assets to achieve the desired deduction and tax result; it can’t create a phantom deduction for assets that don’t pass to the spouse. This result is necessary for policy reasons because there’s no provision in Section 2056 that would subject assets that don’t pass to the spouse to transfer taxes upon her death.
The Turner II decision also raised the “marital deduction mistmatch” issue. To summarize this issue, there’s a question as to whether the estate is entitled to a marital deduction equal to the value of the underlying assets of the LP, which is the way the LP interest will be valued for estate tax exclusion purposes or whether the marital deduction will be limited to the value of the entity, which would be lower given valuation discounts. The issue arises because the estate will only be entitled to a deduction for the interest that will pass to the spouse. If the correct inclusion value is the higher value (fair market value of the underlying assets) and the deduction is for the value of the entity, which will be lower, there will be a mismatch between the value of the inclusion of the asset and the marital deduction allowed. Ultimately, the Tax Court, while raising the question, didn’t provide an answer, deciding to “leave this mismatch problem for another day.”
Third Time’s the Charm
After losing in the first two cases, the estate largely prevailed in the third decision. With the determination in Turner I that the underlying assets of the LP interests were included in the gross estate and that a formula clause wouldn’t trump the technical requirements of Section 2056 to obtain a marital deduction mismatch; the issue in Turner III was how to compute the liability. There were two issues in play. The first issue involved the estate’s argument that the estate tax marital deduction mismatch should be increased by the amount of after death income that was distributed to the spouse. Unsurprisingly, the Tax Court found that as the value of the income wasn’t part of the gross estate, it couldn’t be taken as a deduction because the deduction is only permitted “to the extent that such interest is included in determining the value of the gross estate.” The second issue, which the estate did prevail on, is an important one that has a bearing on all taxable estates—the impact of estate tax apportionment and reimbursement rights.
In computing the estate tax liability, the IRS argued that the amount of the marital deduction should be reduced by the amount of estates taxes that needed to be paid because the only property the estate had readily available to pay the liability was property which was passing to the surviving spouse and so, qualified for the marital deduction. If the amount of assets passing to the spouse was the source of estate tax payments, the IRS is correct that this would reduce the marital deduction and create an even greater estate tax liability given the circular computation that would apply. However, what the IRS didn’t consider in its analysis was the estate’s right to be reimbursed for federal estate taxes paid pursuant to IRC Section 2207B. The estate argued that as it was entitled to reimbursement under Section 2207B from the recipients of the property included by virtue of Section 2036, the value of the marital deduction shouldn’t be reduced because any estate taxes paid from the assets that would pass to the surviving spouse must be replenished.
The Tax Court worked mechanically through the tax apportionment issue. As a starting point in any tax apportionment review, the court first reviewed the decedent’s estate plan to determine whether it directed the apportionment, which, if properly drafted, would take precedent over default state and federal law provisions. The Tax Court determined that the decedent’s estate plan was silent on the apportionment issue, meaning the default federal and state provisions applied. Generally speaking, state law provides for the apportionment of estate taxes, but in addition to those provisions, there are additional federal provisions that could apply to certain non-probate transfers. The decedent died domiciled in Georgia, therefore, the apportionment rules of that state apply. Under Georgia law, estate taxes are to be apportioned to the residue of the estate in the absence of a contrary direction in the estate planning documents. (See Riggs v. Del Drago, 317 U.S. 95 (1942); Georgia Code. Ann. Section 53-4-63(e).) If this provision were applied in vacuum, the IRS’s position would be correct in that the estate taxes attributable to the underlying assets of the LP interests included under Section 2036 would be paid from the property that would otherwise pass to the surviving spouse—thus reducing the marital deduction. However, the IRS position didn’t take into account the federal reimbursement provision of Section 2207B as the federal reimbursement rights have been found to be supplemental to and not in conflict with state law, and Georgia’s apportionment statute specifically states that federal reimbursement rights aren’t impacted by state law. (Compare with Estate of Wycoff v. Comm’r, 506 F.2d 1144 (10th Cir. 1974); aff’g 59 T.C. 617 (1973).) While the estate clearly had a right to reimbursement under Section 2207B, which if exercised would have required that the beneficiaries who received the LP interests included under Section 2036 to pay the estate the amount of taxes incurred because of the inclusion of such property, there’s an outstanding question of whether that right must be enforced.
Whether the fiduciary of an estate must exercise the reimbursement right, like any action of a fiduciary, is one subject to the fiduciary duties applicable to that executor, which is a question of state and not federal law. In Turner, although the estate planning document was silent on apportionment, the Tax Court found that the estate plan clearly intended to pass as much property as possible to the surviving spouse, so the fiduciary must exercise the reimbursement right to achieve the dispositive provisions of the estate plan. The IRS further argued that a reimbursement right shouldn’t save the marital deduction from being reduced, because estate taxes would have to be paid from the property that would pass to the spouse before the reimbursement right could be enforced. The Tax Court agreed that property had to be first paid from the property that would have passed to the spouse before the right was enforceable, but rejected the IRS’s conclusion, because the reimbursement right provided the estate the mechanism to ensure the amount passing to the surviving spouse was unencumbered by estate taxes.
Too often, estate tax apportionment rights are incorrectly viewed as boilerplate language or there’s an assumption that a default method works in every case. What Turner III drives home is that when taxpayers engage in sophisticated estate planning and there will be an estate tax liability, great care and thought must be given into how the client structures his apportionment and reimbursement language. Without doing so, the client runs the risk of creating unintended consequences that could leave the beneficiaries worse off had they not done any planning.