Step Transaction Doctrine Thwarts Attempt to Exclude Gift Taxes

IRC section 2035(c) presumes gifts an individual makes within three years of death are tax-avoidance transactions and eliminates the advantage of such “deathbed transfers” by increasing the gross estate to include gift taxes a decedent paid in the three years immediately before death. In a recent case, the appeals court affirmed that gift taxes a surviving spouse paid in connection with the joint funding of a life insurance trust were, in substance if not in form, paid by the decedent and thus within the three-year reach of section 2035(c).

Willet Brown died in 1993, leaving behind an estate of approximately $180 million. The entire estate was his separate property. Before his death, Willet, with the aid of an estate tax attorney, developed a plan that placed his entire net estate in a marital trust at his death. The transfer under the marital deduction rules of IRC section 2056 allowed Willet to provide financial stability for his wife Betty and deferred estate taxes until after her death.

Willet also created an insurance trust to hold insurance on Betty’s life, presumably so the heirs receiving the estate at her death could use the proceeds to pay estate taxes. Betty had little money of her own so Willet gave her a $3,100,000 gift to fund the life insurance trust. Betty promptly wrote a check from her separate checking account for that amount to fund the trust.

The $3,100,000 payment to the trust was a taxable event, incurring a gift tax liability of $1,415,732. Willet and Betty had elected to be jointly and severally liable for the gift taxes under IRC sections 2513(a) and (d).

At the time of the insurance trust transaction, Willet and his attorney realized it was better for Betty to pay the gift taxes. At age 71 she was more likely to outlive the three-year reach of section 2035(c) than was Willet, age 87. Since Betty did not have the financial resources to pay the tax from her separate property, Willet gave her the money to pay the gift taxes in the form of two checks totaling $1,415,732, which she deposited in her own account. The next day she drew two checks from her personal account, payable to the IRS for the identical amount, to satisfy the gift tax liability. Betty was, however, under no legally enforceable obligation to use the funds in that fashion.

Willet died in 1993, within three years of the gift tax payment. In 1995 the estate filed a federal estate tax return indicating zero tax liability. The zero balance reflected (1) the absence of any tax liability on the gift taxes, based on the assumption Betty paid them and (2) a marital trust made up of the remaining estate (after expected administration expenses), which passed to Betty and was therefore eligible for the marital deduction.

The IRS assessed a tax deficiency on the $1,415,732 plus interest because, in substance if not in form, Willet had paid the gift taxes, which his executors therefore had to include in his estate. Since the surviving spouse lacked the financial resources to pay the gift taxes on the transfer, the IRS collapsed the two-step transaction in which she received the funds from the decedent and paid the tax. Had Betty had adequate funds to pay the tax, section 2513 would govern her payment of the joint and several liability.

The executor filed for a rebate in 1999, raising several claims. First, the gift taxes Betty paid should not have been included in the estate. Second, the estate’s actual administration expenses of $3,592,024, which were deductible from the gross estate under section 2053(a)(2), exceeded the deduction originally claimed ($1,880,000) and the estate was entitled to increase the deduction by $1,712,024 plus the interest paid on unpaid estate taxes.

The IRS argued some of the increased expenses were paid out of funds otherwise earmarked for the marital trust, so any increase decreased the trust and therefore the marital deduction.

The district court ruled in favor of the IRS. It determined that (1) the IRS had properly ascribed the payment of the gift taxes to Willet, (2) the estate was entitled to increase the deduction for administration expenses and (3) the increase must be offset by a corresponding decrease in the marital deduction.

The estate appealed, challenging whether the IRS was entitled to apply the “step transaction” doctrine and the court’s conclusion that any administration expenses paid from the trust corpus decreased the marital deduction.

Result. For the IRS. The Ninth Circuit Court of Appeals affirmed the district court. It concluded the IRS treatment of the two-step transaction was proper. Since Betty had had Willet’s funds for exactly one day, the IRS—by disregarding her fleeting ownership and her role as intermediary—had appropriately characterized the transaction. Even though Betty was under no binding commitment to complete the prearranged plan, she was “unlikely to flout the desires of her husband because it was she, as the initial beneficiary of the estate, who stood to gain if the gift tax wager was successful.” Had Betty truly paid the gift taxes from her own funds, section 2035 would not apply to her payments.

The court also held that section 2056 requires that, when an estate deducts actual administration expenses under section 2053(a)(2) and pays them out of funds otherwise earmarked for the marital trust, the marital deduction must reflect the amount diverted. If the estate elects the administration deduction, those expenses are thereby excluded from the taxable estate. Including those amounts in the marital deduction as well would create a double deduction.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, Tennessee, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.