National Association of Estate Planners and Councils

April, 2013 Newsletter
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Jeff Pennell on Estate of Kite: Will It Fly?

“The Tax Court’s conclusion in Estate of Kite v. Commissioner was that gift tax §2519 applied to a sale of QTIP trust assets in exchange for a private deferred annuity. The opinion is baffling in important areas and makes numerous errors.

And it is likely that the taxpayer will incur and pay no gift tax. Because §2519 only taxes the excess uncompensated value of a QTIP trust over the value of a surviving spouse’s income interest and the Kite annuities were equal in value to the full fair market value of the QTIP trust assets.

The court approved the private deferred annuity transaction itself, and did not apply §1014(e) to deny new basis to assets transferred to a decedent one week before his death, even though the value of those assets passed back to the donor via a formula marital deduction bequest. So, overall, Kite proves to be an important, albeit flawed, taxpayer victory.”

 

Now, Jeff Pennell provides members with his analysis of the Tax Court’s recent decision in Kite.

 

Jeff Pennell is an endowed professor at Emory University School of Law in Atlanta. He is the successor author of the multi-volume treatise, Casner & Pennell, ESTATE PLANNING (8th ed. 2012). In addition to various other practice-oriented, academic, or student texts, he is the author of the BNA Tax Management portfolio on the Marital Deduction.

 

Here is his commentary:

EXECUTIVE SUMMARY:

The Tax Court’s conclusion in Estate of Kite v. Commissioner was that gift tax §2519 applied to a sale of QTIP trust assets in exchange for a private deferred annuity. The opinion is baffling in important areas and makes numerous errors.

And it is likely that the taxpayer will incur and pay no gift tax. Because §2519 only taxes the excess uncompensated value of a QTIP trust over the value of a surviving spouse’s income interest and the Kite annuities were equal in value to the full fair market value of the QTIP trust assets.

The court approved the private deferred annuity transaction itself, and did not apply §1014(e) to deny new basis to assets transferred to a decedent one week before his death, even though the value of those assets passed back to the donor via a formula marital deduction bequest. So, overall, Kite proves to be an important, albeit flawed, taxpayer victory.

FACTS:

In Estate of Kite the surviving spouse (S) was more wealthy than her predeceased husband (D). Very shortly before D died S created an inter vivos QTIP marital trust for D’s benefit. D apparently had more wealth than his exclusion amount, so it does not appear that this was meant to shelter D’s unused exclusion amount (D died in 1995, long before portability was enacted).

Instead, S may have engaged in this planning to generate a new basis under §1014 for very low basis stock that S transferred into the QTIP trust. This inter vivos QTIP trust reserved a secondary life estate for S, and inclusion in D’s estate was offset with a QTIP election made by D’s estate, which qualified the trust for the marital deduction in D’s estate. As a result, S’s stock passed into this trust and then was held for S’s benefit, all tax free due to the two marital deductions.

D died one week after this QTIP trust was created, meaning that §1014(e) should have denied any basis increase for the appreciated stock that S transferred into the trust that was §2044 includible in D’s gross estate. Nevertheless, the court’s footnote 9 reveals that new basis was generated, despite Congress’ intent to preclude such end-of-life planning. See H. Rep. No. 201, 97th Cong., 1st Sess. 188-189 (1981), providing that property passing to D within one year of D’s death will not receive a new basis if inclusion increases D’s gross estate, which correspondingly increases the amount of D’s formula marital deduction bequest back to S. So, new basis on this highly appreciated stock was the first taxpayer victory in Kite.

 

D’s estate created two more marital trusts for the benefit of S. One was a reverse-QTIP trust that sheltered D’s GST exemption. The other was a §2056(b)(5) general-power-of-appointment marital deduction trust. These three trusts participated in the transactions that were central to the case. Which (vastly simplified for these purposes) entailed termination of all three marital trusts, distribution of their assets to S, who placed them into S’s revocable inter vivos trust, which then sold them to S’s children, in exchange for a ten-year deferred annuity payable to S, who died before the deferral period ended. Thus, no payments were ever made in exchange for this wealth, meaning that the private deferred annuity arrangement significantly reduced S’s gross estate. The government sought to preclude this reduction in two different ways.

 

First, the government asserted that the annuity transaction was a taxable gift by S, based on several alternative arguments that the annuities were not full and adequate consideration for the transfers made to the children. Those annuities were structured using the §7520 tables, which applied because the estate established (via a physician’s statement that the government did not challenge) that S was not terminally ill at the time of the annuity transaction.

Although the annuities proved to benefit the children, the court rejected the government’s suggestion that they were not full and adequate consideration for the asset transfers. The court also “disagree[d] with [the government’s] position that the annuity transaction lacked economic substance.” And it rejected the government’s suggestion that the annuity transaction was “illusory,” saying that the annuity agreements were enforceable and that the parties intended to comply with their terms. The court even suggested that S intended to profit from the transaction (which seems unlikely). The result was that the transaction did not constitute a taxable gift because “the annuity transaction was a bona fide sale for adequate and full consideration.” This was a second, significant taxpayer victory in Kite.

 

The government also asserted that the annuity transaction triggered gift tax under §2519 because it involved a disposition of S’s income interest in the two QTIP trusts. Recall that §2056(b)(7) allows the estate tax marital deduction for a trust that grants S only a life estate. In return, §2519 gift tax or §2044 estate tax inclusion occurs when any part of the income interest is assigned or terminates.

The court understood, however, that a mere “conversion of QTIP into other property in which the surviving spouse has a qualifying income interest for life” is not subject to §2519, citing Treas. Reg. §25.2519-1(f). Furthermore, reinvestments, as a substitution of property of equal value for QTIP trust assets, also do not trigger §2519, because there is no diminution in the amount that will be includible in S’s gross estate at death. Having found that the annuities were adequate and full consideration for the assets that S transferred to the children, the government’s second theory also should have failed.

 

Instead, the court held that “liquidation of the QTIP trusts and subsequent sale of [S’s] interests . . . disregarded the QTIP rules. . . . [T]he termination of the QTIP trusts was part of a prearranged and simultaneous transfer of the QTIP trust assets [and] would circumvent the QTIP regime and avoid any transfer tax imposed by section 2519.” Further, the court also turned logic on its head by stating that, because S received adequate and full consideration for S’s QTIP trust interests, S therefore “made a disposition of her qualifying income interest” and triggered application of §2519 gift taxation. This would appear to be a significant taxpayer defeat in Kite, but it is not, and it is wrong.

COMMENT:

The court’s §2519 conclusion is baffling, because the government similarly argued that the annuity transaction effectively constituted a §2514 taxable release of S’s general power to appoint the §2056(b)(5) marital trust. The court rejected that argument because that trust’s assets went into S’s revocable inter vivos trust and thus did not constitute a transfer to another person. So, termination of S’s interest in the QTIP trusts triggered §2519, but termination of S’s interest in the general power trust did not trigger §2514. Because §§2514 and 2519 are the corresponding provisions that tax inter vivos termination of general power and QTIP marital deduction trusts, this inconsistency is inexplicable.

 

The end result was the court holding that “the portions of the annuity value originally traceable to the ownership interest of [the two QTIP trusts] . . . less the value of [S’s] qualifying income interest [in those two trusts] . . . are subject to Federal gift tax” under §2519. That statement also is inverted, because §2519 taxes the full value of a QTIP trust, less the value of the income interest in that trust. The court’s statement therefore confused the annuity amount with the value of the QTIP trust itself. That may make sense, because the estate’s attorneys confirm that the annuity amount was equal to the full value of the trusts, and not just the value of S’s income interests in them. And that is a critical fact.

 

The net result in Kite should be no §2519 taxation at all, because §2519 only taxes the excess uncompensated value of the QTIPs over the value of S’s income interest. Oddly, the court never determined the values that will apply, which means that this element remains for a Rule 155 determination. Because the private deferred annuities were equal to the full value of the QTIP trust assets, what appears to be a taxpayer defeat likely will result in the estate owing no gift tax. (Note, however, that this aspect of the QTIP holding – found in the last two paragraphs of the court’s opinion – is a muddle; it simply is not clear what the opinion was saying.) By all accounts, therefore, the §2519 result is the third significant taxpayer victory in Kite.

 

Attorney Larry Katzenstein, author of the Tiger Tables valuation software, confirms that calculation of the deferred annuity did equal the full fair market value of the trust assets sold. But he also stresses that the Kite annuity transaction may cause capital gain to be realized in the transferred assets, which would not be deferred under current law. In Kite the new basis resulting from the initial transfer of appreciated stock into the inter vivos QTIP, and the different law applicable at that time, may have been critical components for the taxpayer’s success. And failure to litigate the §1014(e) issue may be the government’s most significant error.

 

One final matter deserves mention. The children were made trustee of the marital trusts immediately before their termination. They also were the remainder beneficiaries. Termination of these trusts and distribution of the assets to S meant that their remainders were destroyed (and, presumably, the GST exemption allocated to the reverse-QTIP also was lost). Yet the court’s footnote 37 states that the government “does not raise the issue of whether the . . . children’s termination of the QTIP trusts, and the subsequent liquidation of QTIP trust assets, was a gift from the remainder beneficiaries . . . to the lifetime income beneficiary.” This actually makes sense, because the marital deduction and the payback inclusion of the full value of the marital trusts in S’s gross estate at death means that S is deemed to already own the full fee simple value of these trusts for tax purposes. This should mean that the children could make no gifts to S because, for tax purposes, S already owned the entire value of the marital deduction trusts.

 

It is true, however, that there was no assurance that the children would receive any value from S, and the annuity transaction posed the possibility that S might live longer than the mortality tables predict. In that case the children could have been significantly disadvantaged by this transaction. Whether those facts suggest that the children made a gift apparently did not warrant government attention, and the court similarly dismissed it. And that result is a fourth taxpayer victory in Kite.

 

Finally, it may be difficult in other cases to terminate a trust, as was done in Kite, due to the nearly universal existence of spendthrift trust provisions. And favorable but (according to the court) unique facts also may prevent replication of Kite in another circumstance. Advisors who are intrigued by Kite will want to study the decision and analyze the various steps involved (most of which are summarized without elaboration here), before seeking to mimic the planning involved.

 

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

 

Jeff Pennell

 

CITE AS:

LISI Estate Planning Newsletter #2062 (February 11, 2013) at http://www.leimbergservices.com. Copyright 2013 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

CITES:

Estate of Kite v. Commissioner, T.C. Memo 2013-43 (2013); §§1014(e), 2056(b)(5), 2056(b)(7), 2514, 2519; Treas. Reg. §25.2519-1(f)

H. Rep. No. 201, 97th Cong., 1st Sess. 188-189 (1981)

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