In a division opinion (Estate of Sheldon C. Sommers, et al. v. Commissioner), the Tax Court has held that an estate may not deduct under Section 2053 the gift tax paid by three nieces who had received valid gifts from their uncle in the year before he died, and no estate tax may be apportioned to the nieces under New Jersey law.

Facts

In 2001, Sheldon Sommers sought legal advice because he wanted to give his three nieces (his closest living relatives) certain works of art from his collection and minimize his own tax liability with regard to the transaction. Following his attorneys' advice, Sommers transferred the artwork to Sommers Art Investors, LLC, a limited liability company formed for this purpose, and gifted ownership interests (referred to as "units") in the LLC to his nieces in two stages, one at the end of 2001 and the second at the beginning of 2002.

Sommers and his nieces executed two sets of gift and acceptance agreements in December 2001 and January 2002; the 2002 agreements were ultimately amended to add a provision stating that the donees agreed to pay any gift tax due, as well as any penalties and interest if assessed. The agreements were silent regarding any apportionment of liability for federal estate tax resulting from the gifts.

Sommer's last will, executed in April 2002, directed the executrix, his ex-wife Bernice, to pay all of his debts and expenses to settle the estate and bequeathed to Bernice whatever remained of the estate after those debts were paid.

Preparing to remarry Bernice, Sommers brought suit in Indiana against his nieces in June 2002, challenging the validity of his earlier gifts and requesting that they return the artwork. This litigation, and a similar suit that Bernice pursued in New Jersey, determined that the gifts were valid as a matter of law.

The nieces had not yet paid the gift tax on their uncle's gift by the date of his death on November 1, 2002. Following Sommers' death Bernice filed an estate tax return (Form 706) that claimed a deduction under Section 2053 for the amount of the unpaid gift tax.

Examining the return, the IRS made three adjustments that changed the amount of the taxable estate from $507 to $1.09 million. Specifically, the IRS: (1) included in the gross estate the $510,548 value of the gift tax due on the 2002 gifts because they were made less than three years before death; (2) excluded the $1.75-million value assigned to the artwork that Sommers had transferred to the LLC; and (3) reduced the allowable marital deduction by approximately $2.33 million.

In an earlier case (Estate of Sommers v. Commissioner, T.C. Memo. 2013-8) the parties had disputed when the gifts were actually complete — the estate contended they were not complete until the gift documents were ultimately completed in April 2002, but the IRS argued the gifts were complete when Sommers transferred units in the LLC to his nieces in December 2001 and January 2002. The Tax Court ruled for the IRS; the parties subsequently stipulated that the decedent's gift tax liabilities were zero for 2001 and $273,990 for 2002, and the nieces then paid the gift tax.

In October 2014, the IRS issued its final Form 1273, Report of Estate Tax Examination Changes, valuing the taxable estate at $494,717 and determining estate tax of $220,726. As a result of the estate tax deficiency, the IRS reduced the allowable marital deduction to approximately $1.05 million.

Law and analysis

Section 2053(a) permits deductions from the gross estate for various expenses, including funeral and administrative costs, claims against the estate, and indebtedness on property that is included in the decedent's gross estate.

Section 2056(a) permits a deduction for value of any interest in property passing from the decedent to his or her surviving spouse.

To discourage individuals from making gifts of property shortly before death to keep the property out of their estates, Section 2035(b) provides that for gifts the decedent or his/her spouse makes in the three years preceding the decedent's death, the gross estate will include the amount of gift tax paid.

When a donee agrees to pay the gift tax on a gift she receives, the taxable gift is determined by calculating the difference between the total value of the property transferred and the gift tax on the "net" gift — generally, the full value of the transferred property divided by the sum of the applicable tax rate + 1. A net gift is essentially a part-sale/part-gift, the sale being the amount of the gift tax owed by the donor and paid by the donee and the gift part being the remaining amount of the gift.

Deductibility of gift tax

Although the parties' stipulation on the decedent's gift tax liability meant that $273,990 was includible in the value of the gross estate under Section 2035(b), they disagreed over whether this inclusion may be offset by an equal deduction under Section 2053(a) because the gift tax was not paid until after Sommers' death. The estate argued the deduction was permitted because the obligation to pay the gift tax remained on the donor, regardless of who paid the tax. The estate also acknowledged that allowing the gift tax deduction under Section 2053 would "eliminate the $273,990 gift tax add-back that takes place under [S]ection 2035(b) on literally a dollar for dollar basis." The IRS asserted the gift tax payment was not deductible because the nieces (who were "intervenors" in the instant case) received nothing from the estate and, therefore, did not pay the gift tax as beneficiaries of Sommers' estate. Further, the IRS asserted that "the allowance of a deduction for a liability that will not reduce the net amount passing to Dr. Sommers' other heirs will subvert the purposes of [S]ection 2035."

The Tax Court agreed with the IRS, reasoning that "[b]ecause the estate would have been entitled to reimbursement from the full amount of the gift tax paid, no deduction can be allowed." The court emphasized that the "key question when considering the deductibility under [S]ection 2053(a)(3) of gift tax owed on a net gift, as opposed to inclusion of that amount in a decedent's gross estate under [S]ection 2035(b), is not whether the decedent (or his estate) served as the ultimate source of the funds used to pay the liability but when the decedent parted with that value." Sommers had effectively provided his nieces with the funds to pay the gift tax before he died "because for each intervenor the portion of the value of the units transferred in 2002 that was ultimately determined to constitute a taxable gift was less than the total value of those gifts by the amount of the gift tax." He made these gifts before he died, "withdrawing from his potential estate not only the value of the taxable gifts but also the amount of the tax on the gifts," the court noted, adding that whether the gift tax was paid before or after Sommers' death "should be of no consequence to the allowance of a deduction by the estate."

Effect of debts and expenses on marital deduction

The estate moved that the court determine the estate was entitled to a nearly $1.7-million marital deduction, equal to the value of the decedent's non-probate property Bernice received that was exempt from the estate's debts and expenses under New Jersey law. The estate asserted that all of the debts and expenses for which deductions were claimed on the estate tax return arose under New Jersey law and, therefore, are subject to certain limitations and exemptions set out in New Jersey law.

The court denied the estate's motion, explaining that a determination of whether the estate is entitled to a marital deduction of nearly $1.7 million "turns on the factual question of the extent to which assets otherwise exempt from claims against the estate were used to pay the reported debts and expenses" and the record before the court was not sufficient to make this determination.

Apportionment of estate tax

If necessary, federal estate tax can be collected from beneficiaries who receive, or hold on the decedent's date of death, certain property included in the estate. Similarly, state apportionment statutes "generally provide, in the absence of a contrary direction from the testator, for ratable allocation of the estate tax among all nonexempt recipients of property by reason of the testator's death," the court noted. New Jersey's apportionment statute dates from 1950.

Beginning in 1976, federal estate and gift taxes are computed first by calculating a "tentative tax" on all lifetime gifts (under Section 2052(a)(1)) and subtracting a tentative tax on prior years' gifts (Section 2052(a)(2)). The resulting amount is "reduced by a lifetime 'unified credit' that exempts from tax gifts and lifetime transfers up to a specified amount" (Section 2505(a)). Estate tax liability is calculated similarly, with tentative tax calculated on the sum of adjusted taxable gifts and the taxable estate (Section 2001(b)(1)). As a result, "lifetime gifts can increase a donor's estate tax liability even if the transferred property is not included in the value of his gross estate," the court noted. Further, the court pointed out, no New Jersey court decisions have been issued addressing the extent to which that state's law "provides for apportionment of estate tax to recipients of lifetime gifts."

Under New Jersey's apportionment statute, tax is apportioned among the fiduciary and each transferee with an interest in the gross estate, unless the testator directed otherwise in the will or a non-testamentary instrument. Whether, in the instant case, any of the estate tax can be apportioned to the intervenors depends upon whether LLC units transferred to Sommers' nieces were included in computing the estate tax, "making them 'transferees' within the meaning of N.J. Stat. Ann. Sec. 3B:24-1(d)," the court explained.

Both the estate and the IRS contended that the estate tax should be apportioned to the intervenors under state law. The intervenors opposed the apportionment motion, arguing that (1) gift tax clawbacks do not constitute property of the transferee within the meaning of the New Jersey apportionment statute and (2) apportioning to them any of the estate tax liability would be inconsistent with decedent's intent.

The court interpreted the New Jersey apportionment statute as providing for the apportionment of federal estate tax "only to transferees who receive non-probate property included in the decedent's gross estate." And, the court was unwilling to conclude that New Jersey courts were likely to take the lead of other states "and, in the interest of promoting equity, require apportionment to donees of lifetime gifts not included in the decedent's estate."

The court noted that the IRS had not identified any property in the decedent's gross estate that the intervenors had received or from which they had benefited — pointing out that the LLC units were the only property the nieces had received from their uncle, and that although the gift tax paid on those gifts was included in the gross estate, "the units themselves were not." Because the LLC units the nieces received were not included in the gross estate and, therefore, were not included in calculating the estate tax liability, the intervenors did not, under New Jersey law, constitute transferees to whom estate tax liability could be apportioned, the court concluded.

Implications

The decedent's estate had a reasonable argument that the unpaid gift tax liability should have been a debt of the estate under Section 2053. Section 2501 places the responsibility for paying the tax on the donor of a gift regardless of whether the donor has entered into an agreement with a donee requiring the donee to pay the tax. It is the donor who is required to file a gift tax return and remit the payment of gift tax with the return. Thus, it would seem reasonable that if Section 2501 imposed an obligation on a donor to pay tax and the tax had not been paid at the time of death, the unpaid tax would be a claim against the decedent's estate and deductible under Section 2053. However, the court relied on longstanding precedent that a claim against an estate is deductible only to the extent that it exceeds a right to reimbursement to which its payment would give rise. The court determined that the gift tax liability owed by Sommers was fully reimbursable from his nieces and, therefore, not deductible under Section 2053. Barring such reimbursement, the gift tax liability would have been deductible under Section 2053.

The court declined to read into New Jersey's apportionment law the apportionment to beneficiaries of lifetime gifts of a decedent if these lifetime gifts have the effect of increasing a decedent's estate tax liability. The court noted that many states amended their apportionment statutes after changes in the federal gift and estate tax regimes such that lifetime gifts are included in determining a decedent's estate tax liability. However, New Jersey law has not been amended to take into account this change and the court decided that it would not follow the charge in some state courts that interpreted these pre-1976 apportionment statutes to include lifetime gifts to the extent such lifetime gifts increased a decedent's estate tax liability. The court read these decisions as being more rooted in equity than any statutory mandate. Thus, it will be up to New Jersey to amend its apportionment statute if it perceives that beneficiaries of lifetime gifts should share in any estate tax liability these gifts may cause.

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