February, 2008 Newsletter
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Christiansen - Formula Disclaimer Does Not Violate Public Policy
Jeffrey N. Pennell, Richard H. Clark Professor of Law at Emory University School of Law , author of WEALTH TRANSFER PLANNING AND DRAFTING (West 2005), FEDERAL WEALTH TRANSFER TAXATION (West 2004), successor author of ESTATE PLANNING, the incredible three volume treatise on estate planning originally written by the legendary Harvard Professor A. James Casner, alerts LISI members to an important disclaimer case.
Estate of Christiansen v. Commissioner may be reported as a disclaimer that was partially disqualified under §2518, leading to a corresponding failure to qualify for the estate tax charitable deduction. In the overall scheme of things that portion of the opinion, although noted below, is not very significant.
Instead, Christiansen is important because a unanimous Tax Court held that the disclaimer was effective to pass to charity any increase in the federal estate tax valuation of the estate. And that the formula approach employed was not prima facie invalid — that it did not violate public policy.
In so holding the court rejected the government's consistent assertion that strategic formula provisions that discourage the government from litigating valuation questions are invalid as against public policy. As such, the court refused to extend or apply the authority of Commissioner v. Procter. And while it may not stop the government from bringing this challenge, it likely will empower planners who have been on the sidelines regarding this form of planning prophylaxis.
Christiansen involved a testamentary bequest of the residue of the decedent's estate (which included family limited partnership units) to the decedent's daughter, which she disclaimed to the extent the value of the estate exceeded a formula amount:
determined by reference to a fraction, the numerator of which is the fair market value of the Gift (before payment of debts, expenses and taxes) on [the date of the decedent's death], less . . . $6,350,000 and the denominator of which is the fair market value of the Gift (before payment of debts, expenses and taxes) on [the date of the decedent's death] . . .[all] as such value is finally determined for federal estate tax purposes.
The disclaimed portion passed by the terms of the decedent's will, 75% to a charitable lead annuity trust (CLAT) and 25% to a private foundation (which also was the lead beneficiary of the CLAT). The CLAT remainder was payable to the disclaimant if living at the end of the lead term.
That remainder itself could not qualify for the charitable deduction (and the estate did not claim that it did) but, as found by the court, it also disqualified the attempted disclaimer of the 75% portion passing to the CLAT in its entirety!
As to the 25% balance, passing to the foundation directly, the disclaimer was effective and generated an estate tax charitable deduction as if it had passed directly from the decedent.
The other interesting aspect of the disclaimer was a provision — a "savings clause" — specifying that to
"the extent that the disclaimer . . . is not effective to make it a qualified disclaimer, [the daughter] hereby takes such actions to the extent necessary to make the disclaimer . . . a qualified disclaimer within the meaning of section 2518 of the Code."
The court regarded this provision as ineffective to salvage the 75% portion regarded as invalid.
The estate tax return valued the gross estate at slightly more than $6.5 million, meaning that roughly $150,000 would pass to the two charitable beneficiaries. There was a valuation controversy, which the parties settled, raising the estate tax value to almost $9.6 million, which would have raised the amount passing to the charitable beneficiaries to over $3.2 million.
Because the disclaimer was not effective as to the 75% portion passing to the CLAT, the government ultimately collected estate tax on slightly more than $2.4 million because it was deemed to pass from the disclaimant and not from the decedent for estate tax charitable deduction purposes.
COURT recognizes disclaimer FORMULA as valid!
Before addressing the side-show — disqualification of the disclaimer — let's first address the much more significant issue in Christiansen, resolved in favor of the taxpayer. This involved the strategic, formula disclaimer of any increase in the value of the estate as finally determined for federal estate tax purposes. The court regarded this provision as valid, and that holding is a major taxpayer victory.
Said the majority (which the two dissenting judges joined on this point, making this a unanimous holding):
"We do recognize that the incentive to the IRS to audit returns affected by such disclaimer language will marginally decrease if we allow the increased deduction for property passing to the foundation. Lurking behind the Commissioner's argument is the intimation that this will increase the probability that people . . . will lowball the value of an estate to cheat charities. There's no doubt that this is possible.
But . . . executors and administrators of estates are fiduciaries, and owe a duty to settle and distribute an estate according to the terms of the will . . . . Directors of foundations . . . are also fiduciaries . . . [and] . . . the state attorney general has authority to enforce these fiduciary duties. . . .
We therefore hold that allowing an increase in the charitable deduction to reflect the increase in the value of the estate's property going to the Foundation violates no public policy and should be allowed."
Notwithstanding the curious suggestion that the government's concern is the taxpayer's incentive to cheat the charities, the real issue is a lowball estate tax valuation that, by virtue of the disclaimer passing any added value to charity, discourages the government from bringing any challenge (because any increase in valuation ostensibly generates a matching charitable deduction). The court acknowledged as much earlier in the majority opinion.
As signified by the litigation in this case, and that in McCord v. Commissioner (which employed a similar form of planning to minimize the incentive of the government to bring a valuation challenge), these litigation-discouraging efforts may actually backfire.
And, in this case, notwithstanding its loss on the policy issue itself, the government netted a tax increase by disqualifying a portion of the disclaimer. Had that portion of the planning been accomplished effectively, however, the net effect of Christiansen would have been to quash the government's valuation challenge. In future cases these provisions may actually work as so intended, although it seems unlikely that the government is ready to capitulate on these issues.
DON'T TRY THIS AT HOME!
The qualified disclaimer issue that divided the court slightly (there were two judges writing in dissent on this point) is not a major concern to everyday planning.
But it is a good reminder that accomplishing a qualified disclaimer is not child's play.
Further, the court's disagreement highlights complexity and inconsistency in the regulations. The essential issue was the daughter's entitlement to a remainder in the CLAT, to which 75% of the disclaimed amount passed. The estate did not claim a charitable deduction for the value of the remainder interest in that portion — it clearly did not pass to charity by virtue of the disclaimer.
But the controversy was not over the size of the deduction itself. Instead, it was over whether the remainder interest constituted a severable property interest, the retention of which would not taint the balance of the disclaimer. The court held that it was not severable, notwithstanding that, for charitable deduction purposes, it could be valued separately and the balance of the CLAT value could qualify for the charitable deduction.
For qualified disclaimer purposes the §2518 regulations were regarded as requiring a "vertical slice" (meaning all right, title, and interest in the 75% portion of the full fee simple interest that passed to the disclaimant), rather than a "horizontal slice" (meaning, in this case, the term annuity or the remainder following that term annuity interest).
Further, the charitable deduction regulation dealing with disclaimers (treating property passing to charity as if it passed directly from the decedent, rather than from the disclaimant) requires that the disclaimer satisfy the requirements of §2518. Which, according to the court, this did not.
BETWEEN A ROCK AND A HARD PLACE:
Damning, and confusing, is the regulations' position that, if the transferor had created two separate interests here — a term annuity and a remainder — and gave both to the disclaimant, rejection of one but retention of the other would be a qualified disclaimer as to the one rejected.
But because the full fee simple was given to the disclaimant, who then effectively renounced only the one portion, the regulations preclude qualified disclaimer treatment of the temporal slice — the term annuity payable to the charity — and retention of the remainder.
The dissent (written by the trial judge, from whom the opinion was reassigned), was prescient in suggesting that the result is whacked, but it did not persuade the majority, which evaluated the difference in the various regulations involved and distinguished the two cases.
SAVINGS CLAUSE REJECTED - HERE:
One final matter of interest is the savings clause in the attempted disclaimer, essentially providing that, if the disclaimer was not effective, then the disclaimant "hereby takes such actions to the extent necessary to make the disclaimer . . . qualified."
The court rejected the efficacy of this approach, saying:
"If read as a promise that, once we enter decision in this case, [the disclaimant] will then disclaim her contingent remainder . . . , it fails as a qualified disclaimer . . . as one made more than nine months after [the decedent's] death.
If it's read as somehow meaning that [the disclaimant] disclaimed the contingent remainder back when she signed the disclaimer, it fails for not identifying the property being disclaimed and not doing so unqualifiedly."
MAY BE HOPE FOR (SOME) SAVINGS CLAUSES:
Nothing in the opinion can be taken to suggest that savings clauses such as this are prima facie invalid, although the government's objection to them also is grounded in public policy and is based on Procter. This savings clause did not save the day, but the opinion is not an indictment of savings clauses in general.
BE CAREFUL OUT THERE!
As a matter of general application, however, Christiansen confirms that disclaimer planning itself is fraught with peril, not averted with the addition of a savings clause.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
LISI Estate Planning Newsletter # 1234 (January 30, 2008) at http://www.leimbergservices.com/ Copyright 2008 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.
Estate of Christiansen v. Commissioner, 130 T.C. No. 1 (2008); Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944); McCord v. Commissioner, 120 T.C. 358 (2003), rev'd on other grounds, 461 F.3d 614 (5th Cir. 2006). Treas. Reg. §§20.2055-2(c)(1); 20.2055-2(e)(2)(vi); 25.2518-3(a)(1)(ii) and 25.2518-3(b).
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