by Gary D. Borek
As I pulled into the parking lot of the Title 26 Inn I was still thinking about Professor Ken Joyce's remarks at the award ceremony for the 27th Albert R. Mugel National Tax Moot Court Competition. He had described the authors of the federal estate and gift tax statutes as deceitful "deeming" demons. The problem he had devised for the competition was intellectually challenging and frustrating. It also highlighted a controversial estate planning technique that will remain under constant attack by the IRS, at least until there is a resolution of the controversy by Congress or the Supreme Court.
I was going to the Title 26 Inn to meet with three acquaintances for a few drinks and a discussion about this year's tax moot court problem. Although I was a little late, a well-worn adage assured me of the certainty of their presence, i.e. the certainty of death and taxes. It was a saying I hadn't questioned seriously in the past, but after participating as a judge in the Mugel tax competition I had started to wonder if it might be losing some of its certainty.
My guests were just getting their first round of drinks as I slid into my chair between the Subtitle B twins, Chapter 11 (estate tax) and Chapter 12 (gift tax). I always sat across from the remaining member of our foursome, the Grim Reaper. Grim knew I didn't like sitting next to him but he took no offense, although he always acknowledged my presence with a biting comment or two.
"Ah Counselor, I've been told you were bringing us an instrument of mental torture from the Mugel Moot Court Competition" said Grim as he curled up the corners of his lips in his trademark smile. "Perhaps it is intriguing enough to cause a death or two from anxiety among your fellow members of the bar?"
I told Grim not to get his hopes up. Even those of us who like to practice law usually aren't driven to an early grave by legal dilemmas.
After I order my first drink, we shared our customary comments about the Bills' off-season trades, the performance of the Sabres, and the excitement of the quickly approaching Bisons' opening day. Then we traded the best of the jokes and anecdotes that we had heard over the past month or two. By then it was time for the second round of drinks and Chapter 12, in a display of his impatient personality, said that we should get on with the discussion of the moot court tax problem before Grim got called away for his evening activities.
"All right, I'll get started," I said with a hint of impending doom. "Here's the problem. We have two very clever taxpayers, Cara and Ted Fulslicer. Cara died first leaving an estate of approximately $2.6 million. Her will set up two trusts. The first trust was a `credit shelter trust' naming Cara and Ted's two adult children as the sole beneficiaries. The credit shelter trust was funded with approximately $600,000. The purpose of the credit shelter trust was to make use of Cara's unified gift and estate tax credit, thereby allowing her to transfer the $600,000 to her children without any federal estate tax liability."
"The second trust was funded with approximately one million dollars. The second trust provided that the income was payable to Ted for his life and the remainder to the adult children. Cara's executor timely elected to treat the corpus of the second trust as a qualified terminal interest property, or `QTIP' pursuant to IRC §2056(b)(7), thereby qualifying the entire corpus of the QTIP trust for the estate tax marital deduction, even though Ted's interest in the trust was limited to the income of the trust. The remaining one million dollars of Cara's estate was left to Ted and also qualified for the unlimited marital deduction. Thus, Cara was able to dispose of her $2.6 million estate without incurring any estate tax liability."
Grim was grinning from ear to ear as he ribbed Chapter 11 about the facts I had just presented. "Another taxpayer that escapes your clutches while unwillingly tumbling into mine!" Chapter 11 shot back. "Unlike my brother, patience is one of my virtues Mr. Reaper! I'll get my appropriate share when you visit Ted. He has two estate tax items waiting for me. First, the million dollars left outright to him. Second, IRC §2044 provides that the entire corpus of the QTIP trust will be included in Ted's gross estate for estate tax purposes even though he only has a lifetime income interest in that trust. That's the price his estate will pay for the marital deduction enjoyed by the use of the QTIP trust election made by his wife's estate."
"Yes Ms. 11," I said, "you certainly have reason to expect a share of Ted's estate when he makes his final exit with Grim. Assuming no change in the corpus of the QTIP, and no further accumulations or decreases of Ted's wealth, he should have a total gross estate for estate tax purposes of two million dollars, consisting of the one million dollar cash hoard and the one million dollar corpus of the QTIP trust includable in his estate under IRC §2044. After taking into account the practical effect of his unified credit, you'll get a share of a $1.4 million estate. But the moot court problem presented a method by which Ted might be able to reduce his taxable estate by at least the present value of the reminder interest in the QTIP, and possibly by as much as $1 million, without incurring any gift tax. Thus his taxable estate could be effectively reduced to just $400,000 after taking into account the application of the unified credit."
Grim's smile had turned to a skeptical scowl as he interrupted my presentation: "If only such a result were possible counselor. But even I know that these two tag team tax grapplers will never let him off the mat. If he gives it away, he'll get bitten by Chapter 12." Grim took a bite out of the pretzel stick in his left hand to demonstrate his point. "If he keeps it, he'll be swallowed by Chapter 11." Grim then took a swig of the drink that he held in his right hand. "Either way the Feds get fed. If death was not so entangled with taxes I might not be feared so much."
"Grim's analysis is on target, counselor" said Chapter 12. "If Ted keeps his income interest in the QTIP trust, then IRC §2044 includes the entire corpus in his gross estate. If he disposes of his income interest in the QTIP trust before he dies, then IRC §2519 will apply. That gift tax section treats Ted as a transferor of the remainder interest in the QTIP if he disposes of his income interest in the QTIP. Thus, he is deemed to have made a gift of the children's remainder interest on the date he disposes of his income interest. And when he makes such a gift, even though it is only a "deemed" gift, I'll be there to collect my share."
"Well," I said, "I'd agree that is the way the IRS expects things to work out. But there are a couple of divergent interpretations of the language of the particular statutes involved. One of those interpretations just might allow Ted to achieve his goals."
"What do you mean by divergent?" queried Chapter 12. I replied with one of my favorite analogies: "Suppose I told you that I would give you a quarter for every one dollar bill in your wallet. Now let's suppose you have four one dollar bills. How much money do you think you'll have at the end of our transaction?" Mr. 12 thought out loud "I had four one dollar bills to start with, I got four quarters from you, and I didn't have to pay any tax, at least not yet so I'll have five dollars." Grim's grin returned as he jumped into the conversation "Maybe, maybe not, Mr. 12. It all depends on how you interpret counselor Borek's proposition. Under your interpretation you are to get a quarter for each dollar bill in your wallet. But I'm betting the counselor meant that he would give you a quarter in exchange for each of those dollar bills. That leaves you with his four quarters and him with your four dollars. I don't see that as divergent, though. I'd call it devious, Counselor."
"O.K." I said somewhat apologetically "maybe it wasn't such a good example, but in any event the problem we are dealing with focuses on two legitimate but divergent interpretations of a common phrase in the tax code."
"And what would that language be?" asked Grim.
"Adequate and full consideration!" shouted Chapter 12, suddenly waking from his trance-like state of contemplation about the quarters-for-dollars analogy. "Ted will try to transfer to his children some or all of his cash hoard for adequate and full consideration, thereby reducing the assets in his gross estate without incurring a gift tax liability."
"But but," stammered Grim, "if he exchanges the cash for `adequate and full consideration' then he receives something of equal value in return. Whatever he gets in return will simply replace the cash in his gross estate,keeping the total value of his estate exactly the same as before the exchange."
"Unless," I said with my best Grim-imitating grin, "in exchange for the cash hoard he receives something that was already included in his estate for estate tax purposes."
"That sounds as silly as that stupid grin looks on you," said Grim.
"Maybe not, Grim," said Chapter 11 (referring to my statement rather than my contrived facial expression), "because under IRC §2044 Ted's kids own something that will already be included in Ted's gross estate for estate tax purposes."
"Yes, yes!" exclaimed Grim, "I forgot about the reminder interest in the QTIP. It is owned by the children but it is deemed to be a part of Ted's gross estate for estate tax purposes."
"That's right Grim" continued Chapter 11, "Ted can remove some of the cash from his gross estate by exchanging it with his kids for their remainder interest in the QTIP. His acquisition of the QTIP remainder interest, however, will not increase his gross estate for estate tax purposes because it is already deemed for inclusion in his gross estate by IRC §2044 whether or not he actually owns it."
"Now, let's slow down for a minute" said Grim. "I'd like to make all this a little more concrete by putting some numbers on the table. Let's assume that the remainder interest in the QTIP has a value of $500,000. If Ted pays his kids $500,000 for the remainder interest in the QTIP trust then he still has $500,000 of the cash hoard in his estate."
"That's right," I said, "but he has effectively reduced his potential taxable estate by $500,000 without incurring a gift tax. And with a little more fancy footwork, he might be able to exclude the remaining $500,000 from his potential taxable estate - also without incurring a gift tax."
Grim was intrigued. "I can't wait to hear your scheme for this one, Counselor. I'll bet it makes your quarters-for-dollars scam look like a cheap card trick."
"Well," I said, "let me clarify a few things. First, it is not my scheme. You can thank, or should I say blame, Professor Joyce for all of my knowledge about this. He in turn will tell you that you can thank, or again blame, Congress for what Professor Joyce calls 'deceiving by deeming' in the estate and gift tax statutes. Second, I'm going to take you through this in small steps and change the facts slightly to highlight the issues addressed by the moot court problem. Third, this is no sure thing. The IRS has some strong arguments backed by case law, presumed legislative intent, and policy. So please exercise some self restraint as I go through it all."
"Wait, Counselor," said Grim. "We'd better get another round of drinks before you start."
(Continued on next page.)
Tax Notesby Gary D. Borek The Uncertainty of Death with Taxesand the meaning ofAdequate and Full ConsiderationPart 2May 1998 This is part two of an article about the estate and gift tax issues addressed at UB's 27th Annual Albert R. Mugel National Tax Moot Court Competition. You may recall that I was discussing those issues over a few drinks at the Title 26 Inn with Chapters 11 (estate tax) and 12 (gift tax) of Subtitle B of the Internal Revenue Code and the Grim Reaper. "I think I'd like to recap our discussion so far before we get into the depths of this controversy," I said as our waitress returned with our third round of drinks. "We are dealing with estate tax planning for Ted Fulslicer. His wife, Cara, had died several years earlier. She had an estate of $2.6 million. Her will gave $600,000 to her adult children in a credit shelter trust. She gave one million dollars to Ted. The remaining one million was placed in a QTIP trust under which Ted had a lifetime income interest and the remainder was payable to the adult children of Ted and Cara. Her executor made a timely election to qualify the QTIP trust for the unlimited marital deduction. After applying her unified gift and estate tax credit, Cara's entire estate passed to Ted and the adult children without any estate tax liability. "We've concluded that in the absence of any estate planning by Ted, his gross estate for estate tax purposes will be two million dollars, consisting of the one million dollar cash hoard and the one million dollar corpus of the QTIP trust. The corpus of the QTIP trust is includable in Ted's estate pursuant to IRC §2044 because an election was made to qualify the entire QTIP trust for the marital deduction in Cara's estate, even though Ted had only a lifetime income interest in the trust. After taking into account the practical effect of Ted's unified credit, Ted's taxable estate will be $1.4 million." " And don't forget that we assumed a present value for the remainder interest of the QTIP trust," said the Grim Reaper. " Yes, Grim, I think it was $500,000," said Chapter 11, "and counselor Borek was proposing that Ted reduce his potential taxable estate by purchasing the QTIP remainder interest from his children for $500,000, thereby reducing his potential gross estate to $1.5 million." Chapter 12 then asked: "Why is Ted's gross estate for estate tax purposes reduced by $500,000 when he purchases the QTIP remainder, which also has a value of $500,000?" Grim threw a piercing glance of frustration at Chapter 12 as he opined, "Why can't your memory be as long as some of your code provisions? Then we wouldn't have to repeat ourselves so much. Now, for the last time (and write this down, please, so we don't go over it again), the remainder interest in the QTIP is already included in Ted's gross estate for estate tax purposes because of IRC §2044, even though he doesn't own it. So his actual acquisition of the remainder interest doesn't add any value to his gross taxable estate. But by paying $500,000 for the QTIP remainder interest he has removed $500,000 of his cash hoard from his estate. The net result is a $500,000 reduction without incurring a gift tax liability." Grim then turned to me with an expression of suspicion as he asked: "Now what is the issue about the meaning of `adequate and full consideration' that you referred to earlier, Counselor?" I was happy to be getting to the heart of the matter. "Well, Grim, IRC §2512(b) states that `Where property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift, and shall be included in computing the amount of gifts made during the calendar year.' Thus, if Ted's receipt of the remainder interest in the QTIP trust is not `adequate and full consideration' for purposes of IRC §2512(b), then Ted has made a gift of the $500,000 to his kids for gift tax purposes." Grim leaned back in his chair and threw his hands in the air as he exclaimed "I think it's time you switched to a less potent drink, Counselor. We already agreed that the remainder interest in the QTIP trust had a present value of $500,000; so there is no doubt that the kids parted with adequate and full consideration in exchange for the $500,000 cash. If the $500,000 from their father was a gift, then their net worth would have increased by $500,000. But it didn't, because they transferred their remainder interest in the QTIP to Ted in exchange for Ted's $500,000." " You are right, Grim" said Chapter 12, "if we think of consideration purely in the economic sense. For gift tax purposes, however, we may need a more restrictive definition to prevent the depletion of one's estate without incurring a gift tax liability. Otherwise we might as well repeal the estate tax because only the uninformed will be subject to it. Everyone else will simply avoid it by making lifetime transfers." " And what would you propose Mr. 12?" Grim asked very cautiously. Chapter 12 paused for a moment and then replied, "Well, a definition might be difficult to articulate so I'll take an approach similar to Justice Stewart's definition of pornography: I know what isn't consideration when I see it. In other words, whatever consideration may be, it is not something that is already included in the gross estate of the transferor for estate tax purposes." Grim was annoyed. "My, my, Chapter 12! I do believe you make this stuff up as we go along! Have you any authority for your convoluted definition, or should we call it an un-definition, like an un-cola?" " As a matter of fact" said Chapter 12, "there exists excellent authority for my definition and it has been applied by the IRS to a situation analogous to our hypothetical. In Revenue Ruling 98-8, 1998-6 I.R.B. 1 (2-9-98) the IRS stated: the courts have recognized that the receipt of an asset that does not effectively increase the value of the recipient's gross estate does not constitute adequate consideration for purposes of the gift and estate tax. See Commissioner v. Wemyss, 324 U.S. 303, 307 (1945), 1945 C.B. 416, ("The section taxing as gifts transfers that are not made for `adequate and full [money] consideration' aims to reach those transfers which are withdrawn from the donor's estate.") A companion case to Commissioner v. Wemyss, Merrill v. Fahs, 324 U.S. 308 (1945), 1945 C.B. 418, and the cases that preceded it, involved situations where A, an individual, transferred property to B, A's spouse (or future spouse), in exchange for B's relinquishment of marital rights in A's property. The Court held that B's relinquishment of the marital rights did not constitute adequate and full consideration for A's transfer because the assets subject to the marital rights were already includable in A's taxable estate. The property subject to dower and marital rights is clearly included in the gross estate of the property owner. Thus, to conclude that the relinquishment of dower and marital rights by the spouse of the property owner constituted adequate and full consideration for a transfer by the property owner for gift tax purposes would effectively subvert the legislative intent and statutory scheme of the gift tax provisions. Merrill v. Fahs, at 311-312. See also, Commissioner v. Bristol, 121 F.2d 129, 136 (1st Cir. 1941). " So in our hypothetical, Ted will be treated as having made a gift of the $500,000 transferred to his children because the remainder interest in the QTIP which he received in return is not `consideration' for gift and estate tax purposes." " Not so fast, Chapter 12!" I said. "First, I'm not certain that the IRS correctly interpreted the Wemyss and Merrill cases. I think the holdings of those cases are limited to the issue of whether marital rights relinquished by A are `money or money's worth' for purposes of the gift and estate tax. Second, two recent cases, Wheeler v. U.S., 116 F.3rd 749 (5th Cir. 1997) and D'Ambrosio v. CIR, 101 F.3d 309 (3rd Cir. 1996), cert. denied, 117 S.Ct. 1822 (1997) disagree with the IRS's analysis of the Wemyss and Fahs opinions. Finally, if we accept the net result sought by the IRS then we must be willing to accept an expansion of the part-gift/part-sale concept to reach a legal fiction in which one side of the transaction (Ted's) is a gift, while the other side of the transaction (the children's) is a sale. Other provisions of the Code, such as the transferee liability provision under IRC §6901 et seq., would need adjustment to fit within this legal fiction." As I began to rise from my seat Chapter 11 placed his hand on my shoulder and inquired about my intended destination. " Home," I replied with an air of confidence. " I don't think so, Counselor," said Chapter 11, giving it his best James Cagney. "You said earlier that Ted might be able to remove all of his cash hoard from his estate for estate tax purposes without incurring a gift tax liability. My brother and I would like to hear just how you think that might be done." " Oh...I forgot about that," I said as I returned to my seated position. "O.K. But I'm going to use what I think is the most straightforward approach. The moot court problem used a more complex method, mostly to give the competitors more things to argue about. And I'm not going to discuss the collateral issues because I can't stay all night." " Fair enough," said Chapter 11 as Chapter 12 nodded in agreement. " First, I'll have Ted buy a home with his one million dollar cash hoard. Then Ted transfers a remainder interest in the home to his children in exchange for his kid's remainder interest in the QTIP. He can easily accomplish this by executing a deed that transfers all his rights, title, and interests in the property with the exception of a life interest reserved for himself. Of course we will assume that the value of the remainder interest in the home is $500,000. Now Ted will argue, as he did before, that the transaction is not a gift for gift tax purposes because he received `adequate and full consideration' in exchange for the remainder interest in the real property. When he dies, his executor will argue that the real property is not includable in his gross estate because he held only a life interest in the real property." " No, no, no!" interjected Chapter 11. "Your plan won't work. IRC §2036 will include the entire value of the real property in Ted's gross estate because he retained the right of possession and enjoyment for his lifetime." " But," I shot back, "Ted's executor will argue that IRC §2036 does not apply because Ted received adequate and full consideration for the remainder of the real property." " I don't think so, Counselor," said Chapter 11. "First, you have the same problem with the definition of `consideration' that we discussed earlier. Second, the IRS has successfully argued in several cases that the consideration received in exchange for a remainder must be equal to the value of all the interests in the property, present and future, to be `adequate and full'." " Name them!" I insisted. Chapter 11 obliged by listing several cases, including Gadow v. U.S., 11 Cl. Ct. 808 (1987), aff'd, 897 F.2d 516 (Fed. Cir. 1990); U.S. v. Past, 347 F.2d 7 (9th Cir. 1965); U.S. v. Allen, 293 F.2d 916 (10th Cir. 1961), and Estate of Gregory v. CIR, 39 T.C. 1021 (1963). " Oh, I'm so sorry, Chapter 11," I said in a voice mocking sympathy for her, "I forgot to tell you that Ted lived in the Third Circuit, or was it the Fifth Circuit? Whichever. AND BECAUSE OF THAT ALL OF THE CASES YOU CITED ARE IRRELEVANT! Ted's estate tax argument with the IRS will be governed by the holdings of Wheeler v. U.S., 116 F.3rd 749 (5th Cir. 1997) and D'Ambrosio v. CIR, 101 F.3d 309 (3rd Cir. 1996), cert. denied, 117 S.Ct. 1822 (1997), both of which think the line of cases you just cited are wrong!" " So if Wheeler and D'Ambrosio are followed, Ted and Cara waltz around, over, and under the gift and estate tax," said Grim in a voice of disbelief. " It would appear that way," I replied "but Professor Joyce did throw in an imaginative argument the IRS might use to get some estate tax out of Ted's estate. That argument focused on a literal interpretation of the inclusion provisions with regard to the QTIP trust. In essence, the argument attempts to regain what was lost from the lifetime transfer by a `double inclusion' of the QTIP trust in Ted's estate." " It must be very imaginative, Counselor," said Grim, "for a court to allow the IRS to tax something twice." " Not really, Grim," I said. "The IRS could simply argue that the QTIP trust is included in Ted's estate by IRC §2044 because of the use of the marital deduction election by his pre-deceased wife, and that the QTIP trust is included a second time because Ted owned the entire interest in the QTIP trust upon his death. That might work for the IRS if it is presented as an alternative, rather than an additional, argument. Otherwise the IRS will look like a hog and be at risk of becoming a victim of the rule the IRS applies to taxpayers claiming deductions: piglets get fed, hogs get slaughtered." " Now, I must be on my way," said Grim as he rose slowly from his chair. Chapter 11 couldn't put her hand on Grim's shoulder, mostly because it didn't appear that Grim had any shoulders. His black robe hung from his head to the floor without revealing a discernible body underneath. "I'm off to meet a few penniless souls tonight." " Oh, how sad," said Chapter 11, "for a person to die without a penny to his name!" " Not the way I see it after our discussion tonight," replied Grim. "A person who dies penniless either had a very good estate planner or just very good timing."
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