Can a taxpayer reduce the value of a gift because the beneficiary agrees to pay the gift and estate tax?
Taxpayer Says: The fair market value of the gift should be reduced because the beneficiaries agreed to pay the estate and gift tax on the gift. A buyer would have to assume that liability and would reduce the purchase price to reflect the tax due.
Internal Revenue Service Says: The agreement of the beneficiaries to pay the tax had no effect on the value of the gift because the applicable state law required the beneficiaries to pay the tax anyway. The fair market value should not be reduced.
From Internal Revenue Code Section 2501(a): Imposes a tax on the transfer of property by gift.
From Internal Revenue Code Section 2502(c): The donor is primarily responsible for paying the gift tax.
From Internal Revenue Code Section 2512(a): The amount of a gift of property is generally the value of the property on the date of the gift.
From Internal Revenue Code Section 2035(c): A decedent’s gross estate is increased by the amount of any gift tax paid by the decedent or the decedent’s estate on any gift made by the decedent during the three-year period preceding the decedent’s death.
From Treasury Regulation 25.2511-2(a): The gift tax is imposed upon the donor’s act of making the transfer, rather than upon receipt by the donee, and it is measured by the value of the property passing from the donor, rather than the value of enrichment resulting to the donee.
From Treasury Regulation 25.2511-1(g)(1): Donative intent on the part of the donor is not an essential element for gift tax purposes; the application of gift tax is based on the objective facts and circumstances of the transfer rather than the subjective motives of the donor.
From Treasury Regulation 25.2512-1: The value of the property is the price at which it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.
THE CAUSE OF THE DISPUTE
With some exceptions, when you make a gift in the three years before your death, the value of the gift is included in your estate. In addition, the gift tax you pay on the gift is also added back to your estate. This “lookback” rule was enacted to prevent deathbed transfers made to reduce estate taxes.
Typically, the value of the gift is based on its fair market value at the time of the transfer. That’s defined as the amount a willing buyer and a willing seller would agree the gift is worth. When the gift is encumbered with liabilities that the buyer must assume and pay, the buyer would expect a reduction in the selling price to account for those liabilities.
In 145 T.C. No. 7 (Steinberg), the taxpayer entered into a binding gift agreement with her four daughters after lengthy negotiations in which all parties were represented by separate attorneys. The gross value of the gifts transferred to the daughters was $109,449,307. Each daughter agreed to pay the gift tax due on the gift, as well as any estate tax that might be due if the taxpayer died within three years of making the gift.
In keeping with the agreement, the daughters each transferred $10 million to an escrow fund set up with a bank. Of the $40 million, $32,437,261 was used to pay the federal gift tax that resulted from the gifts, and the remaining balance was set aside to pay any estate tax liability.
The taxpayer hired a qualified appraiser to determine the fair market value of the total gift. The appraiser concluded the value of the gift on the date it was made in 2007 was $71,598,056. He determined the present value of the gifts was the fair market value of assets transferred by the taxpayer less the liabilities (tax or otherwise) assumed by the daughters.
The taxpayer timely filed Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for tax year 2007. She reported taxable gifts of $71,598,056 and total gift tax of $32,034,311. She attached a summary of the gift agreement, which included a description of the appraiser’s determination of the value of the net gifts, to the Form 709.
The IRS increased the value of the taxpayer’s gifts to her daughters from $71,598,056 to $75,608,963, for a total gift tax increase of $1,804,908. The IRS disallowed the discount made for the daughters’ assumption of the estate tax liability. The IRS argued that the daughters’ assumption of the estate tax liability in the gift agreement did not create any new burden on the daughters or benefit for the taxpayer because the daughters would have had to bear the burden of the estate tax liability either under New York law or as beneficiaries of the estate.
The court disagreed, saying the taxpayer could have moved or changed her will prior to her death, and that there was no certainty the daughters would be the beneficiaries of the will.
The question then became the correct fair market value of the property rights transferred under the gift agreement. This is the “willing buyer/willing seller” test, and the court had to decide whether the gift agreement would cause a buyer to demand a discount. In reaching a decision, the court considered whether the assumption of the estate tax liability was a detriment to the daughters and a benefit to their mother (the taxpayer).
WHAT WOULD YOU DECIDE?
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THE COURT’S DECISION
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Detriment to the Donee — A willing buyer of the property rights pursuant to the gift agreement would recognize that to obtain the properties, he or she would also have to assume both the gift tax and the estate tax liabilities associated with the transfer.
The gift tax and the estate tax liabilities did not exist before the gift agreement. These liabilities arose as a result of the gift agreement. The gift agreement was the product of lengthy negotiations. The daughters had to agree to assume the liabilities in order to gain the benefit of the property they received under the gift agreement. The taxpayer would not have been willing to transfer the properties without requiring any estate tax liability to be satisfied. Any hypothetical recipient of the properties who assumed the liabilities would insist on a reduction of the purchase price to reflect his or her assumption of any estate tax liability.
The daughters’ assumption of the estate tax liability is a detriment to the daughters because it might result in reductions in the values of the gifts they received if the taxpayer died within three years of the gifts. A hypothetical willing buyer of the properties would recognize that to obtain the properties transferred, he or she would need to assume both the gift tax liability and the estate tax liability and would demand that the price be reduced to account for both of the liabilities.
Benefit to the Donor — The estate depletion theory of gift tax can be applied to determine what constitutes consideration in money or money’s worth. Under the estate depletion theory, a donor receives consideration in money or money’s worth only to the extent that the donor’s estate has been replenished.
Under federal tax law the cost of estate tax liability is generally borne by the donor’s estate and not the donee of the gift.
When the taxpayer made the gifts to her daughters, she accrued both gift tax liability and the potential estate tax liability. When the daughters assumed the gift tax liability, the taxpayer’s assets were relieved of the gift tax liability and therefore her estate was replenished.
Likewise, when the daughters assumed the estate tax liability, the taxpayer’s estate was relieved of that estate tax liability. This assumption has replenished the taxpayer’s assets.
The daughters’ assumption of the estate tax liability might relieve the taxpayer’s estate of a portion of its estate tax liability. If the taxpayer died within three years of the gift, her estate would have recourse against the daughters.
Accordingly, the willing buyer would demand that the price of the properties be reduced to account for the estate tax liability.
We conclude that in the circumstances present in this case a hypothetical willing buyer and willing seller would take into account the daughters’ assumption of estate tax liability in arriving at a sale price. We further conclude that the daughters’ assumption of the estate tax liability reduces the value of the taxpayer’s gift to the daughters by $5,838,540.