January 03, 2011 - Gifts (Portfolio 845)
By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, D.C.
In this case, decided by the federal District Court for Massachusetts on August 10, 2010 (____ F. Supp. ____, Civil Action No. 09-10427-RWZ), Lauren and Margit Breakiron were the owners of property in Nantucket that each of them transferred (to the extent of an undivided one-half interest) in 1995 to separate QPRTs. Under the terms of the QPRTs, each Settlor retained the right to live on the property for a period of 10 years. At the expiration of the 10-year term, the property was to pass outright to each of the Settlors' then-living children, Craig Breakiron and Lauren Breakiron Gudonis, in equal shares as tenants-in-common. This transfer occurred on September 27, 2005.
Following this transfer, Craig expressed an interest in disclaiming his one-half tenant-in-common interest in favor of his sister, Lauren. He executed two disclaimers (one for each one-half interest) on April 10, 2006, more than 9 months after the dates of the 1995 transfers creating Craig's remainder interest in the two QPRTs. As such, the disclaimers failed to meet the technical requirements of a "qualified disclaimer" under Code §2518(b)(2)(A) and (B), which require that a disclaimer be made by the later of (i) the date that is 9 months after the transfer creating the interest, or (ii) the date on which the disclaimant attains age 21. Under applicable Treasury regulations, a disclaimer must be made within this 9-month "window" even if the disclaimant's interest in the disclaimed property is not then vested or is then contingent.
An attorney consulted by Craig early in 2006 had incorrectly advised Craig that his proposed disclaimers would be valid if executed within nine months after the expiration of the QPRT's Trust Term (before June 27, 2006), rather than within nine months after the QPRT's creation (before June 27, 1996).
On September 19, 2006, a new Transfer Certificate of Title was issued, naming Lauren Breakiron Gudonis as sole owner of the property. Craig later learned that the disclaimers were ineffective to avoid the imposition of taxes on the transfer. By executing ineffective disclaimers, Craig caused the property to be passed from his parents to himself (as tenant-in-common), and he then re-gifted his interest to his sister Lauren. Therefore, he, as a donor, became liable for federal gift tax. The IRS thereafter obtained a gift tax lien on the property in the amount of the outstanding tax (approximately $2.3 million).
In October 2008, Craig filed an action for reformation in the Massachusetts Land Court, to which the United States was a party, and the United States removed to federal court. That court addressed both the rescission and the resulting gift tax issues in a decision published at 452 Mass. 1008, 893 N.E.2d 351, 352 (Mass. 2008).
Craig argued that, but for his counsel's erroneous tax advice, he would not have executed the disclaimers. He claimed that, "had he known the disclaimers would not qualify for reduced tax treatment, he would have transferred the property to his sister by creating a new QPRT, naming her as the beneficiary, which would have significantly reduced his tax liability." By seeking rescission, Craig sought to void the existing Certificate of Title and obtain a new Certificate of Title naming him and Lauren each as owners of an undivided one-half (1/2) interest in the property as tenants-in-common.
The government argued that the federal gift tax became due and owing once the invalid disclaimers were executed, and that rescission could not abrogate Craig's obligation to pay federal gift tax.
The court noted, citing Comr. v. Bosch,2 that, in general, "when a substantive rule underlying a federal tax matter is based on state law, federal courts in effect sit as a state court and, absent a decision on the matter sub judice by the state's highest court, apply state law."
Under Massachusetts law, as interpreted by the federal district court, a written instrument, including a disclaimer, may be reformed or rescinded in equity on the grounds of mistake when there is "full, clear, and decisive proof" of the mistake. "The touchstone of the inquiry is the intent of the disclaimant."
In this case, the court found "decisive evidence of the [disclaimant's] intent to minimize transfer tax consequences." Thus, the court ruled, "[t]he disclaimers are inconsistent with Craig's intent and are therefore now rescinded. This rescission was granted nunc pro tunc, as of the date of their execution on April 16, 2006."
On the separate question of whether the rescission should affect Craig's federal tax liability, the court noted the existence of two conflicting lines of cases:One line of cases holds that state law reformation of the original transfer does not abrogate federal tax liability. The rationale underlying this line of cases is that because neither party to the state law reformation proceeding has an interest in paying federal tax liability on the transfer, reformation under state law may not be the product of a bona fide adversary proceeding; rather, the possibility of "collusion" to avoid federal liability exists. This is especially so where the IRS was not a party to the state reformation proceeding and therefore cannot represent the federal government's interest in collecting federal taxes.
By contrast, another line of cases holds that where the underlying transfer has been reformed by a state court due to mistake, such reformation does abrogate a party's duty to pay federal taxes. The rationale underlying these decisions is that the original transfer was defective ab initio because the original instrument contained a mistake. As a result, there was no completed gift.3 [Citations omitted]"
In this case, however, the court found that there was no issue regarding collusion, and thus the two lines of cases could be reconciled, particularly in view of the fact that, in the instant case, the federal court, not the state court, granted rescission of the disclaimers: The IRS is a party to the proceeding. Moreover, the IRS does not dispute that Craig made a mistake when he executed the disclaimers. While the mistake was not a mere "scrivener's error," it was a mistake at the time he disclaimed-not a hindsight decision by plaintiff to avail himself of a tax advantage. The IRS had an opportunity during this proceeding to adduce evidence that plaintiff's execution of the disclaimers was something other than a mistake, and did not… . Accordingly, reformation of the disclaimers is conclusive of the federal tax liability.4
For these reasons, the court granted the rescission and ruled that it would bind all parties and would be conclusive for federal tax purposes. The court further observed that "a necessary consequence of the government's position is that Craig now receives the property back but would still be required to pay a gift tax. Under this logic, Craig could be taxed again when he ultimately disposes of the property."5
We note first that, in this case, it would probably behoove any taxpayer seeking a rescission of a transaction for gift tax purposes to join the IRS as a party to the rescission, whether in state or federal court.
Second, we observe that, at least for income tax purposes, there is a doctrine, reflected in Rev. Rul. 80-58,6 that a transaction may be rescinded with no adverse tax effect if the rescission is accomplished by the end of the same taxable year in which the rescission occurred. This ruling is based on the annual accounting period principle, which requires the determination of income at the close of the taxable year, without regard to subsequent events. Rev. Rul. 80-58 probably is inapplicable to gifts, and, in any event, the rescission in question in Breakiron v. Gudonis occurred in a different taxable year than did the disclaimer. However, it is easy to see that permitting rescission of a gift, even within the same taxable year, might allow a gift made early in the year to be rescinded without consequence where it became clear later in the year that the value of the gifted property had fallen.
Guidance regarding the scope and application of the rescission doctrine is on the IRS's and Treasury's 2010-2011 Priority Guidance List under "General Tax Issues," which may or may not include transfer tax issues. The New York State Bar Association Tax Section, in August 2010, submitted a letter to Treasury and IRS requesting clarification of the rescission doctrine, including the application of that doctrine to gift transactions.
This commentary also will appear in the January 2011, issue of the Tax Management Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Lischer, 845 T.M., Gifts, and Lischer, 846 T.M., Gifts to Minors, and in Tax Practice Series, see ¶6320, Gift Taxation.
3 Slip Op. at pp. 7-8. For a case illustrating the first view see Van Den Wymelenberg v. U.S., 397 F.2d 443 (7th Cir. 1968). For the second, see Dodge v. U.S., 413 F.2d 1239 (5th Cir. 1969). The Dodgeline of cases is premised, in part, on the provision of the gift tax regulations [Regs. §25.2511-2(b)] which states that a gift is complete and thereby subject to the gift tax only when the donor has "so parted with dominion and control as to leave him [or her] with no power to change its disposition." Thus, the court observed, "when the donor avails himself or herself of the equitable right of reformation, the donor has not parted with dominion and control because there is an equitable right to change the disposition." Id. at p. 11.
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