July 19, 2022
Tax Court concludes both IRS and estate misunderstood distinction between 'depository' and 'drawee' banks
The Tax Court has held (Estate of William Demuth, Jr., et al. v. Commissioner, Dkt. No. 18724-19) that, due to an apparently erroneous concession by the IRS based on both parties' misunderstanding of the distinction between a "depository bank" and a "drawee bank," only seven of 10 checks written before, but paid after, the decedent's death are includable in his gross estate.
William Demuth executed a power of attorney (POA) in January 2007, appointing his son Donald as his agent. The POA authorized Donald to give gifts to William's issue up to the amount of the annual federal gift tax exclusion, which he did between 2007 and 2014.
William's health began to fail in the summer of 2015. On September 6, 2015, Donald wrote 11 checks totaling $464k from William's investment account at Mighty Oak Strong America Investment Company. William died less than a week later, on September 11. Mighty Oak paid one of the checks before William's death. Payees of three checks deposited them on September 11, and Mighty Oak paid them on September 14. In short, Mighty Oak had not paid 10 of the 11 checks (totaling $436k) before William's death.
In filing the estate tax return as executor, Donald reported the value of the Mighty Oak account by excluding the value of all 11 checks. Following an audit, the IRS issued a deficiency notice determining that the value of the Mighty Oak account had been understated by the $436k value of the 10 checks. The estate timely filed a Tax Court petition.
Tax Court's analysis and decision
In its opening brief, the IRS conceded that three of the checks (valued at $70k) were not includible in the estate because they had been "'credited by drawee banks'" before William's death.
The Tax Court noted that under IRC Section 2033 the value of a gross estate includes the value of all property in which the decedent had an interest at the time of death. Cash that belongs to a decedent at the time of death is included in the gross estate (Treas. Reg. Section 20.2031-5).
A gift is not considered complete until the donor has "parted with dominion and control as to leave him no power to change its disposition," the court noted, citing Treas. Reg. Section 25.2511-2(b). To determine whether the checks constituted completed gifts, the court relied on state (Pennsylvania) law. A valid inter vivos gift in Pennsylvania requires "a clear, satisfactory, and unmistakable intention of the giver to part with and surrender dominion over the subject of the gift, with an intention to invest the donee with the right of disposition beyond recall, accompanied by an irrevocable delivery, actual or constructive."
Therefore, just delivering a check to a donee does not complete a gift in Pennsylvania. This rule "makes sense given that the Pennsylvania Commercial Code allows the drawer of a check to "stop payment of any item drawn on [their] account or close the account" before the check is cashed, the Tax Court noted. The court concluded that "so long as the drawer of a check can make a stop-payment order on that check, the delivery of the check is revocable" under Pennsylvania law. The Pennsylvania Commercial Code provides a list of events that can trigger expiration of "a reasonable time for the bank to act," deeming a gift to be complete. One such time is when the "drawee bank accepts, certifies, or makes final payment of the check."
The Tax Court concluded that because Mighty Oak had not accepted, certified or made final payment on any of the 10 checks, a stop-payment order could have been placed on any of them, so the gifts they represented were not complete. Absent the IRS's concession in its opening brief, this would have been the end of the court's analysis and the value of all 10 checks would be included in the estate.
The IRS had conceded that the three checks deposited by payees on the day William died were not includible in the estate, because they were "credited by drawee banks" before William's death. This concession was erroneous, the court concluded, because the IRS appeared to use the term "drawee bank" when the correct term was "depository bank" — and merely depositing a check with one's depository bank does not complete a gift. The drawee bank must pay over the funds for the gift to be complete, the court emphasized.
A "drawee bank is the entity ordered by the drawer to make payment whereas a depositary bank is the entity that a payee uses to deposit a check. Drawee banks are often distinct entities from depositary banks; they are not interchangeable," the court stressed. "This terminological distinction is critical," the Tax Court wrote, because the IRS's opening brief conceded that three checks were not includible in the gross estate "seemingly on the basis that the checks had not been 'credited by drawee banks' before [the] decedent's death."
Although the IRS had not asked the Tax Court to allow it to withdraw its concession, the court concluded that it could not permit the concession to be withdrawn because the petitioner had relied on the position the IRS took in its opening brief. Therefore, the three checks valued at $70k were excludable from the estate, but the seven others totaling $366k were includable.
The Pennsylvania rules cited by the Tax Court are not unlike the rules that exist in most states — as long as the donor can stop payment on a check given as a gift, the gift is revocable and, therefore, incomplete. This determination by the court is well-settled law. It is why taxpayers are advised not to make gifts of checks that are meant to qualify for the gift tax annual exclusion amount at the end of the year — if the check is not accepted, certified or paid by the drawee bank before the end of the year, the gift is not complete and, therefore, is not a gift made in the year in which the check is written. Knowing that Mr. Demuth was in such poor health, the son holding the POA should have certified the check and delivered them to the donees. In the case of a certified check, the amount of the check is debited from the donor's account at the time it is certified — not when it is deposited by the donee.
The Tax Court's distinction between a depository bank and a drawee bank is crucial in determining when the gift of a check is complete. A gift of an amount by check is complete when the drawee bank accepts, certifies or pays the check, not when it is deposited by the donee with his or her depository bank. The IRS failed to make this distinction and it cost the government the estate tax on $70,000 ($28,000).
In reviewing the amounts of the checks, they all look to equal the maximum gift tax annual exclusion amount in the year Mr. Demuth died ($14,000), except one that was written for $240,000 (unless this gift was to a trust in which the beneficiaries had a withdrawal right). Completed gifts that qualify for the annual exclusion for gifts under IRC Section 2053(b) are generally not brought back into a decedent's estate even if they are made within three years of the decedent's death. Assuming all of these gifts would have qualified for the gift tax annual exclusion, the failure to complete the gifts of these checks before Mr. Demuth's death cost his estate (and ultimately his heirs) $146,400 ($366,000 x .4).
Estate of DeMuth v CIR