Even when individuals diligently engage an estate planning attorney and effect appropriate estate planning techniques, ever-fluctuating family relationships or unexpected illness or death may disrupt such estate plan and, thus, cause undesirable transfer tax consequences. Estate of Sommers v. Commissioner, 149 T.C. No. 8, is a prime example of when an estate planning technique — net gifting — proved harmful by increasing the value of the gross estate, even though net gifting seemed entirely appropriate to the client’s facts and circumstances existing on the date of execution.
In Estate of Sommers, the decedent made lifetime gifts to his three nieces by transferring artwork to an LLC and, subsequently, membership interests to the nieces over a two-year period (tax years 2001 and 2002), to take advantage of valuation discounts and annual exclusion amounts. The nieces signed an agreement stating that they would be responsible for any gift taxes relating to the gifts of membership interests (otherwise known as a net gift). Shortly thereafter, the decedent remarried his ex-wife. The decedent died five months later.
Prior to his death, the decedent initiated a lawsuit (possibly due to the renewed marriage) against his nieces arguing that the gifts were not completed gifts. After the court held that the decedent made completed gifts in tax years 2001 and 2002, the nieces paid the gift tax liability of $273,990.
As a result of gifting the membership interests within three years of his death, the value of the membership interests was included in his gross estate. Additionally, the $273,990 gift tax payment was included in the value of the gross estate under §2035(b). The executor of the decedent’s estate, the surviving spouse, however, asserted that the gift tax payment was deductible under §2053(a) and Reg. §20.2053-6(d).
The court held that the gift tax payment was not deductible because “an estate is entitled to deduct a claim under §2053(a)(3) only to the extent that the amount owed exceeds any right to reimbursement to which payment of the claim would give rise.” The court found that the estate would have had an enforceable right to reimbursement from the nieces if they had not paid the gift tax. Citing the net gift analysis from Estate of Sachs v. Commissioner, the court found that the nieces served only as conduits and the decedent was the ultimate gift tax payor. If not for the three-year clawback, the decedent would have withdrawn from his potential estate the value of the taxable gifts and the amount of tax on such gifts. The gross-up rule is necessary to prevent such excess value (the gift tax on the net gift) from escaping, and therefore the decedent’s estate from circumventing, the transfer tax system.
Net gifting can be a very valuable and effective estate planning tool if executed properly. The estate planning attorney, however, should make the client aware of the risks involved in making net gifts. Below are a few practical points that can be extrapolated from Estate of Sommers.
First, the opinion makes clear that the decedent engaged in the above-mentioned estate planning technique “to reduce — or, ideally, eliminate—any gift tax on the gifts.” This estate plan clearly failed to achieve the primary objective and actually increased the decedent’s estate by the amount of the gift tax paid by the nieces. This case highlights that there is always a risk of the estate planning technique failing when making net gifts.
Second, the health of the decedent should be a significant factor when making net gifts. This should include a comprehensive examination of past, present, and potential future health issues, which may be an issue beyond the estate planner’s control where the client does not accurately represent the state of his or her health. Although this case does not describe the decedent’s state of health prior to his death, it is easy to imagine a similar situation in which the decedent is not in good health, possibly unknown to the estate planning attorney, and undertakes such estate planning regardless.
Third, if the decedent is in poor health or has an ongoing health condition that makes survival of the three-year period a risky proposition, is there an ethical obligation to persuade the decedent to not make net gifts? Pursuant to the facts and circumstances in Estate of Sommers, namely that the value of the gift (and therefore the value of the gift tax that could be added to the decedent’s estate if he dies within three years) versus the overall value of the estate, there were likely no ethical issues with the net gifting transaction. If the value of the net gift is significantly greater, however, it may be prudent for the donor and the donee to each be represented by separate counsel. Additionally, the donor or donee may independently determine that he or she does not want to risk the potential additional transfer tax burden.
Fourth, determine whether the gift and acceptance agreement should include a provision under which the donee will be responsible for any estate or generation-skipping transfer tax (in addition to the gift tax) resulting from the gift. Having the donee agree to pay any potential estate tax in the event that the decedent dies within three years of the gift, may work to the advantage of the donor by reducing the value of the gift. The agreement in Estate of Sommers only mentioned payment of gift tax, thus leaving the estate to pay tax on the excess value (the gift tax on the net gift).
For everything necessary to research, plan, and implement strategies for maximizing your clients’ control while minimizing taxes, take a free trial to the Estates, Gifts and Trusts Portfolios Library.
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