Charitable Residuary Bequest Denies

Take-Away: In a surprise decision from the Tax Court, a fairly common type of charitable residuary bequest was denied a charitable estate tax deduction, raising some concerns about the use of this type of ‘reduce-to-zero’ type of formula gift.

Reported Case: Estate of Howard Moore v. Commissioner, Tax Court Memo, Cas. Now. 21209-09 and 22082-09 (April 7, 2020.)

Facts: The facts are too long to go into much detail. Suffice it to say that this is one of those ‘bad facts make bad law’ decisions, where the hyper-aggressive estate planning by an old individual in poor health shortly before death blew up. Two key facts to that planning was a sale of a multimillion dollar farm to a family limited partnership (FLP) in exchange for partnership interests. The interests were then transferred to a revocable trust. The revocable trust had as one of its provisions a formula based residuary bequest to a charitable lead trust tied to the size of the taxable estate after application of the decedent’s applicable exemption amount. That estate planning formula chitable disposition to the charitable trust was, therefore, a the ‘reduce-to-zero’ type, much like the reduce-to-zero funding formula found in many marital deduction trusts. In short, as the value of the assets retained by the decedent grew on IRS audit, the more likely it was that the ‘excess’ in audit value would pass to the charitable remainder trust, for which a charitable estate tax deduction would be claimed. Ultimately the estate claimed at $2.0 million charitable deduction.

Planning Malpractice?: One example of the bad planning advice that demonstrates the aggressiveness of this Mr. Howard’s planning was that when the farm was ‘sold’ by Mr. Howard to the FLP, he reserved in that sale a life estate interest. While the goal was to attempt to shift the value of that appreciating real estate out of his estate through FLP valuation discounts, his retained life estate in the farm resulted in the full value of the farm being included in his taxable estate. [IRC 2036.] Consequently, any effort to convert an appreciating asset to a limited partnership interests and other convoluted estate planning maneuvers was, practically ruined by an obviously retained life estate.

Tax Court: The Tax Court made a couple of interesting findings, in addition to noting the ‘screw-up’ of retaining a life estate in the farm that was sold to the FLP.

Charitable Deduction Denied: The Howard estate claimed a $2.0 million charitable deduction for the assets that it said passed to the charitable trust on Mr. Howard’s death. The IRS claimed that no charitable deduction was available to the extent the formula would adjust to reflect any increase in the value of the decedent’s estate arising from the IRS’s audit of the estate tax return. In denying the charitable estate tax deduction, the Tax Court Judge found:

Charitable deductions are allowed only for the value of property in the decedent’s gross estate if transferred to a charitable donee ‘by the decedent during his lifetime or by will.’ [Reg. 20.2055-1(a).] We have repeatedly denied charitable deductions where the donation turned upon the actions of the decedent’s beneficiary or an estate’s executor. Charitable deductions must be ascertainable at the decedent’s death. [Reg. 2055-2(b)1).] Whether [Mr. Moore’s] living trust would get the additional funds from the irrevocable trust to transfer to the charitable trust was not ascertainable at Moore’s death but only after an audit, followed by a determination that additional property should be included in Moore’s estate….. What we don’t know is if the charity would get any additional assets at all.

The problem with this analysis is that the formula used by Mr. Moore’s trust bequest was almost identical to a marital deduction reduce-to-zero formula fractional gift. Following this Tax Court Judge’s analysis, any residuary ‘self-adjusting’ marital deduction bequest presumably would be denied. In the typical formula based marital deduction context there is no certainty that there will be any marital bequest because the deceased spouse’s gross estate may be less than their unused exclusion amount. Normally marital deductions are not disqualified due to this uncertainty. In short, whether there is a dispute with the IRS which entails an increase in the size of the decedent’s gross estate because of either valuation or includibility should be irrelevant in a formula-based charitable residuary bequest, just like it is for marital deduction purposes.

Double Counting Assets Under IRC 2043(a): The Tax Court Judge struggled with an on-going analysis of another Tax Court decision with regard to IRC 2043(a). This is the section that is in response to the ones bring back into the decedent’s taxable estate the value of assets that were previously removed from the individual through lifetime transfers. In the Moore case, an asset was ‘sold’ by Mr. Moore to an FLP in exchange for consideration; the consideration was retained by Mr. Moore until his death. Yet IRC 2036 requires the full value of the ‘sold’ real estate in Mr. Moore’s taxable estate, the result being ‘two’ values when before the transaction there was only one ‘value’, the real estate pre-transfer.  In the Moore decision, the Tax Court Judge noted:

Excluding the value of the partnership interest from Moore’s gross estate might appear the right result because it would prevent its inclusion in the value of the estate twice. The problem is that there is nothing in the text of Section 2036 that allows us to do this. Nothing in Section 2036 allows us to exclude anything from the estate only to include the value of the transferred property.

This ‘problem’ arises because the inclusion of the value of an asset in the decedent’s estate under one of the string provisions of the Tax Code [IRC 2036 to 2038] is in addition to the basic inclusion provision of IRC 2033. Restated, the value of assets received as consideration for the lifetime transfers with strings are ignored in 2033. Normally there is no ‘double counting’ of assets with the application of a string provision, because they are the result of a lifetime gratuitous transfer, with no consideration coming back to the donor. The problem surfaces when the donor receives back valuable assets or interests in assets, yet the string provision still applies, that can then create the double value inclusion situation.

IRC 2043 is intended to provide a ‘consideration offset’ and give some type of relief for the decedent’s estate from this double valuation inclusion situation. The Moore decision attempts to expand upon the interpretation and application of the IRC 2043 ‘consideration offset’ calculation that was initially offered a couple of years ago in the Powell decision.

Like the Powell decision, it is fairly clear that the judges are struggling to identify exactly how the offset is to be calculated, especially when the consideration received by the transferror appreciates or depreciates over time. Note that the value of the asset that is returned to the transferror’s taxable estate under a string provision is valued as of the date of the transferror’s death, but far less clear is how to value the consideration received to apply the offset.

The key point here is that if the consideration received by the transferror appreciates over time, the transferror will be hurt, as that additional appreciation over the initial value that was received, will be included in the transferor’s taxable estate under IRC 2033. Thus, only the value initially received in exchange on the string transfer will be used to offset against the the IRC 2036 value inclusion.

Conclusion: The bad news coming from Moore is twofold. First is that there is now some concern about the effectiveness of a formula based residuary estate tax charitable deduction. Hopefully this part of the decision will be appealed.

Second, there is now a second Tax Court decision that addresses the consideration offset under IRC 2043(a) which hurts the decedent’s estate if the consideration received in a string transaction appreciates, because that individual’s estate may actually end up paying more in estate tax than if the estate planning transaction had never taken place.

About the only good news with regard to the Moore decision is that it is a Tax Court Memo decision, which means that it is not binding precedent.