Tiffany M. Nicholson, Duane Morris

Recent developments in transfer taxes should be on every estate planner’s radar. In 2018, the following three cases made waves.

First, in United States v. Paulson, 331 F. Supp. 3d 1066 (S.D. Cal. 2018), the U.S. District Court of the Southern District of California held the former trustee of a decedent’s revocable living trust, who had been succeeded as trustee nine years after the decedent’s death, personally liable under Section 6324(a)(2) of the Internal Revenue Code of 1986, as amended (the code), for the full estate tax obligation of the decedent’s estate, including estate taxes which had accumulated beyond the period for which he served as trustee.

Section 6324(a)(2) of the code provides:

If the estate tax obligation imposed by Chapter 11 is not paid when due, then the … trustee … who receives, or has on the date of the decedent’s death, property included in the gross estate under Sections 2034 to 2042, inclusive, to the extent of the value, at the time of the decedent’s death, of such property, shall be personally liable for such tax.

Thus, for liability to attach under such section, the property in question must be included in the gross estate as provided under any of Sections 2034 to 2042 of the code. Acknowledging that requirement, the former trustee argued that the trust assets did not fall under any of Sections 2034 to 2042 of the code. Instead, he suggested that the trust assets fell under Section 2033 of the code, which provides that “the value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.”

The district court disagreed, finding instead that the property fell squarely within Section 2038 of the code, which provides that:

“The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer … by trust or otherwise, where the enjoyment thereof was subject at the date of the decedent’s death, to any change through the exercise of a power … by the decedent alone or by the decedent in conjunction with any other person … to alter, amend, revoke or terminate.”

The district court reasoned that the nature of a revocable living trust and the power that remains with the settlor to amend or revoke such instrument is precisely the type of property contemplated by Section 2038 of the code.

The former trustee also argued that it would be inequitable to hold him liable under Section 6324 of the code for the portion of the estate tax obligation that accumulated during the period for which he was no longer serving as trustee. However, the district court found the trustee’s argument meritless, stating simply that Section 6324 of the code makes no remarks about equity.

Next, in Cahill v. Commissioner of Internal Revenue, 115 T.C.M. (CCH) 1463 (T.C. 2018), the Tax Court considered a motion for partial summary judgment by an estate that Sections 2036(a)(2), 2038(a), and 2703(a) of the code were inapplicable to the valuation of a decedent’s interest in certain split-dollar life insurance agreements (SDAs) for estate tax purposes.

In Cahill, the decedent established an irrevocable trust, the primary beneficiaries of which were the decedent’s son and his descendants. The decedent then entered into a series of SDAs via his revocable trust whereby such trust advanced $10 million to his irrevocable trust to enable the irrevocable trust to purchase life insurance policies on the lives of the decedent’s son and the decedent’s son’s wife. The revocable trust financed the $10 million premium with a five-year term loan from a trust company. The total death benefit under the policies was $79.8 million.

The terms of the SDAs provided that in exchange for the revocable trust’s funding of the policy premiums for the irrevocable trust’s benefit, the revocable trust received the right to terminate the SDAs upon mutual agreement with the trustee of the irrevocable trust. Upon termination, the irrevocable trust had the option to retain the policy, in which case it would then pay to the revocable trust the greater of the total premiums paid or the cash surrender value of the underlying policy. If the irrevocable trust declined its option, the policy would transfer to the trust company that financed the $10 million loan in full or partial satisfaction of the revocable trust’s debt. Additionally, the SDAs provided that upon the death of the insured, the revocable trust would receive the greater of the remaining loan balance, the total premiums paid, or the cash surrender value of the underlying policy. The irrevocable trust in turn would receive any excess of the death benefits beyond what it paid to the revocable trust.

The decedent died in 2011. On the federal estate tax return for the decedent’s estate, the decedent’s executors claimed that the aggregate value of the decedent’s rights under the SDAs had a value of $183,700. The estate argued that because the decedent’s right to terminate the SDAs was conditioned upon the mutual consent of the trustee of the irrevocable trust, and because it would never make economic sense for the irrevocable trust to consent to termination, the termination rights were essentially worthless. On that basis, the estate valued its interests under the SDAs based upon the life expectancies of the decedent’s son and his wife, with the amount payable to the revocable trust upon their deaths under the SDAs discounted to present value.

The Internal Revenue Service (the IRS) issued a deficiency notice adjusting the value of the decedent’s interest in the SDAs to $9,611,624, or the cash surrender value of the policies as of date of the decedent’s death. The IRS argued that this approach was warranted under alternative theories applying Sections 2036(a)(2), 2038(a) and 2703(a) of the code.

Similar to Paulson, in Cahill, the Tax Court addressed whether certain property held in trust at the decedent’s death was part of the decedent’s gross estate.

The estate argued that Sections 2036 and 2038 of the code were inapplicable because the decedent’s retained rights under the SDAs were insufficient to justify application of those sections, namely because the decedent’s right to terminate the SDAs could only be exercised upon mutual agreement with the irrevocable trust. The Tax Court rejected this argument on the basis that Sections 2036 and 2038 contemplate retained rights exercisable “in conjunction with any other person.”

In addition, the Tax Court found that the revocable trust’s transfers to the SDAs were evidently not for full and adequate consideration as the value, per the estate, of what the decedent received in the SDA transaction, and were “not even close” to the $10 million expended by the decedent’s revocable trust.

As an alternative to Sections 2036 and 2038 of the code, the IRS argued that Section 2703(a) was applicable. Section 2703(a) of the code provides:

“The value of any property shall be determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option agreement, or right), or any restriction on the right to sell or use such property.”

Agreeing with the IRS, the Tax Court held that the fact that the revocable trust’s termination rights as to the SDAs were conditioned upon the consent of the irrevocable trust should be disregarded for purposes of valuing the decedent’s rights under the SDAs for estate tax purposes. Further, the Tax Court held that Section 2703(a) of the code was applicable to the SDAs because, per the estate’s own valuation of its interests in the SDAs, the transaction represented an exchange for less than fair market value, and the SDAs contained restrictions on the parties’ ability to unilaterally terminate the agreements.

Three days after its decision in Cahill, the Tax Court decided another motion for partial summary judgment on the issue of whether Section 2703(a) of the code was applicable for estate tax valuation purposes to SDAs with termination restrictions. In Morrissette v. Commissioner of Internal Revenue, Order No. 4415-14 (T.C. 2018), the decedent’s estate argued that Section 2703(a) of the code was inapplicable to the valuation of interests in the SDAs at issue.

In support of its position, the estate argued that the decedent’s only interests in the SDAs were in death benefits, which rights were not subject to any restrictions defined in Section 2703(a)(2) of the code. The court disagreed, siding with the IRS’s position that the decedent’s interests in the SDAs included the decedent’s termination rights. The court cited Cahill for the proposition that termination restrictions of the kind present in the Morrissette SDAs, where the parties could mutually agree to terminate the arrangement but neither party could unilaterally terminate the arrangements, were restrictions for purposes of Section 2703(a) of the code.

Tiffany M. Nicholson is an attorney in Duane Morris’ Philadelphia office. She practices in the area of wealth planning.