In Estate of Clyde W. Turner, Sr., et al. v. Commissioner, 151 T.C. No. 10, the Tax Court rejected the Service's assertion that an estate must reduce its marital deduction by amounts of federal estate and state death taxes attributed to the value of property transferred to a family limited partnership (FLP) approximately one year before the decedent's death. Additionally, the Court held that the estate may not increase its marital deduction by post-death income that was not included in the gross estate.

Facts

In April 2002, Clyde Turner and his wife established an FLP to which each of them: (1) contributed approximately $4.33 million; and (2) received in exchange a 0.5% general partnership interest and 49.5% limited partnership interest. By January 2003, Turner had transferred partnership interests totaling more than 21.7% as gifts to family members. Turner died testate in February 2004.

Two Tax Court decisions involving the estate preceded the instant case. In Estate of Turner v. Commissioner, T.C. Memo. 2011-209 (Estate of Turner I), the Tax Court held that the value of the property Turner had transferred to the FLP must be included in his gross estate under Section 2036(a).

In Estate of Turner v. Commissioner, 138 T.C. 306 (2012) (Estate of Turner II), the Court held the estate was not entitled to a marital deduction for the value of the property that was included in the estate under Section 2036(a) (the Section 2036 inclusion), because those assets would not actually pass to the surviving spouse.

Before the Court issued its decision in Estate of Turner II, the IRS filed a computation for entry of decision calculating an estate tax deficiency of $362,822; after the decision, the IRS amended this calculation to $513,821, explaining that the first calculation had allowed a deduction for the interest on the estate tax but had not correspondingly reduced the marital deduction by the same amount. The estate objected, asserting two alternative computations, reflecting estate tax deficiencies of $144,136 or $341,073.

Following Estate of Turner II, the parties asked the Court to determine how the marital deduction should be computed under Section 2056. To make this determination, the Tax Court needed to decide whether: (1) the estate had to reduce the marital deduction by the amounts of federal estate and state death tax attributable to the value of gifts made during the decedent's lifetime but nonetheless included in the gross estate under Section 2036(a), and (2) the estate was entitled to increase the marital deduction by post-death income that was generated by estate assets, reported on the estate tax return and paid to the surviving spouse.

Federal estate and state death taxes

The IRS asserted that the estate must reduce the marital deduction by the federal estate and state death taxes imposed on the estate because the only property available to pay the taxes is property that would otherwise pass to the surviving spouse and qualify for the marital deduction. The estate disagreed, asserting its right of recovery under Section 2207B.

Section 2207B generally allows an estate to recover from the property recipient an amount bearing the same ratio to the total estate tax paid as the property value bears to the taxable estate, provided any part of the gross estate on which tax has been paid includes the property value included in the gross estate by reason of Section 2036.

Section 2001(a) imposes tax on the transfer of the taxable estate of every decedent who was a US citizen or US resident. Under Section 2031(a), the value of the decedent's gross estate includes the values of interests described in Sections 2033 through Section 2045. Section 2056(a) provides a marital deduction, allowing the value of certain property passing from the decedent to his or her surviving spouse to be deducted from the value of the gross estate. Section 2056(b)(4) requires that, in determining the value of any interest in property that qualifies for a marital deduction, one must take into account the effect that the tax imposed by Section 2001, or any estate, succession, legacy or inheritance tax, has on the net value of the property that qualifies for the marital deduction. Under Section 2010, the estate may claim a credit (unified credit) that reduces its estate tax liability.

Although the executor must pay the estate tax under Section 2002, no code section dictates which beneficiary's interest bears the burden of the tax and Turner's will did not expressly address how the tax burden should be apportioned. In Turner, applicable state (Georgia) law required that federal estate and state death taxes be paid from the residue. The IRS and the estate looked to two particular provisions of Turner's will to identify and define the residue. Provision 8 expressed Turner's intent to leave assets to his wife undiminished by any estate or death tax and having a value "equal to the maximum marital deduction." Provision 9 established a trust for the benefit of the couple's children and grandchildren if the decedent had any remaining unified credit. The estate asserted that Provision 9 constituted the residuary clause of the will because it referred to the "rest, residue, and remainder" of property. The IRS asserted that no trust came into existence under Provision 9 (because the decedent had no unified credit remaining at death), and, therefore, the only property available from which to pay the taxes was the property passing to the surviving spouse under Provision 8.

The Court noted that the "parties' argument regarding which provision of the will constitutes the residuary clause, however, fails to focus on the important facts in this case." The estate reported on the estate tax return (Form 706) that an 18.8525% FLP interest was allocated to Mrs. Turner under Provision 8 and the remaining 8.9029% FLP interest was allocated to a credit bypass trust under Provision 9. The Court noted that, because it held in Estate of Turner I that the value of the Section 2036 assets must be included in the value of the gross estate, the FLP allocations have changed. The Court explained that:

• The Section 2036 inclusion exhausted the unified credit under Section 2010 and generated an estate tax liability
• It was not necessary to fund a credit bypass trust under Provision 9 because the unified credit had been fully used
• Both parties' computations recognized that: (i) the trust would not be established, and (ii) Mrs. Turner was entitled to a distribution of the value of any property included in the estate, except for the Section 2036 assets (FLP interests) that Turner transferred during life

Because Turner transferred the Section 2036 assets during his life and they were not available to the executor to fund the payment of federal estate or state death tax liabilities, the IRS contended that the assets that would pass to the surviving spouse and qualify for the marital deduction were the only source from which to pay the tax liabilities, so the marital deduction must be reduced. Essentially the IRS asserted that Mrs. Turner "is the only heir and the assets cannot pass to her undiminished by taxes."

Citing Section 2207B, the estate asserted that those to whom Turner transferred the Section 2036 assets during his lifetime would bear the burden of any taxes attributable to the Section 2036 inclusion. The Tax Court agreed. The Court noted that Turner's will clearly stated his intention not to reduce the marital deduction but was silent on: (1) how estate taxes should be paid or apportioned, and (2) how right of recovery under Section 2207B should be determined.

The Court rejected the IRS's argument that the marital deduction cannot be preserved because the Section 2207B right of recovery can be exercised only after taxes have been paid. The Court explained that Section 2207B gives the executor a means to replenish the estate assets used to pay federal estate and state death tax liabilities attributable to the value of the Section 2036 assets that are included in the estate. With the value of the Section 2036 assets already included in the calculation of the gross estate, "any recovery under [Section] 2207B should not increase the gross estate but will enable the executor to distribute to the surviving spouse the net value of the estate, undiminished by the tax liabilities attributable to the [Section] 2036 inclusion," the Court stated.

Ultimately, the Court held that the marital deduction need not be reduced here because:

1. The tax liabilities are attributable to Section 2036 assets
2. The estate has the right to recover the amount paid under Section 2207B
3. The estate must exercise its recovery right while satisfying the decedent's intention that the surviving spouse receive her share undiminished by the estate's tax obligations

Post-death income

The estate asserted that the marital deduction should be increased by the amount of income generated by estate assets (post-death income) and allocated to the marital share. Disagreeing, the IRS argued that, because income from estate assets was not included in the gross estate, it did not constitute a deductible interest under Reg. Section 20-2056(a)-1(a) and (b) and cannot increase the marital deduction.

Agreeing with the IRS, the Court noted that Section 2056(a) determines the value of the taxable estate by deducting from the gross estate's value an amount equal to the value of any interest in property passing from the decedent to the surviving spouse; a marital deduction is permitted only to the extent that the interest attributed to the surviving spouse is included in determining the value of the gross estate.

The estate based its contention on regulations (Reg. Section 20.2056(b)-4(d)) that explain how the marital deduction is calculated. The regulations generally provide that the marital share includes income that is produced by property during the administration of the estate and payable to the surviving spouse. The IRS argued that the post-death income interest is not a deducible interest under the regulations because it was not included in the gross estate, and the estate misinterpreted Reg. Section 20.2056(b)-4(d).

The Court allowed that portions of Reg. Section 20.2056(b)-4(d) "are confusing" but concurred with the IRS's position that the regulation defines marital share "solely for purposes of calculating the effect of administration expenses on the marital deduction. It does not purport to increase the marital deduction otherwise allowable under [Section] 2056, nor could it. Section 2056(a) limits the marital deduction to the value of the interest that is included in the value of the gross estate."

Although post-death income may increase the "marital share" for purposes of calculating the effect that administration expenses have on the marital deduction, the regulations cannot increase the amount of the marital deduction under Section 2056, the Court concluded.

Implications

IRS success on the first issue addressed by the Tax Court would have resulted in an interrelated calculation that would have substantially increased the amount of the gross estate subject to estate tax. The decedent's will contemplated that no estate tax would be due in the event that he passed and had a surviving spouse. As is typical of estate planning for couples, the first-to-die spouse's will establishes what is commonly referred to as a "credit-shelter trust" to utilize the decedent's remaining unified credit and the rest is either given to the surviving spouse outright or to a marital trust. The first-to-die spouse's estate going to the credit-shelter trust is shielded from estate tax to the extent of the decedent's remaining unified credit, and the estate going to the marital trust is shielded from estate tax by the marital deduction.

The couple's plan not to have a taxable estate on the first-to-die spouse's death did not quite work the way they intended. Because the IRS successfully argued in Turner I that the assets in the FLP were includable in the decedent's estate, the decedent had no remaining unified credit (it was absorbed by the includible FLP assets) and, thus, the credit-shelter trust was never created. Those assets were also not available to place in the marital trust because they had already been given to family members during the first-to-die spouse's lifetime. The inclusion of the FLP assets also caused the first-to-die spouse's estate to be taxable and the only assets to pay the tax were going to the marital trust. Because the assets that would be used to pay the resulting estate tax could not pass to the marital trust, the IRS argued that these assets were subject to estate tax, resulting in a higher estate tax than just the estate tax due on the amount of the FLP assets brought into the estate under Section 2036.

The Tax Court correctly decided that, under Section 2207B, the estate had a claim against the parties holding assets that were includable in the decedent's estate for the amount of estate tax the included assets generated. Thus, the parties holding assets included in the decedent's estate under Section 2036 were responsible for the estate tax, and the assets going to the marital trust would not be diminished by the tax.

Of course, the problem could have been averted if the decedent's will had been clear about which assets would bear the payment of estate tax.

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