Four Contradictions

ven in an area of law where legalese is shortened to acronym form, there appears to be a recent epidemic of doubletalk. We find ourselves asking perplexing questions: Will the sun be setting on the sunset provision that essentially repeals the estate tax repeal in 2010?

Can one disclaim an undivided interest…after dividing it from one's property? If transfers by a decedent were intended as gifts, treated as gifts, and taxed as gifts, can they be recharacterized as payments years after the fact? And if the IRS takes a position that is contrary to a basic and accepted principle, can it still make the argument that it was "substantially justified"?

Let's examine the sunset provision of the estate tax repeal and these other contradictions affecting estate taxation and planning in recent months.

The Setting Sun

The Estate Tax Phased Out

Context is everything here. A tax repeal in a free-standing Tax Reform might have been phased in over many years without a sunset provision. Because the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was part of a Budget Reconciliation Act, it is subject to the rules established in the Congressional Budget Act of 1974 (CBA). With the Byrd Rule in effect, provisions affecting revenues beyond the budget years being reconciled could have been eliminated. A sunset provision avoided the application of the Rule. As a result, the estate tax repeal, as well as the other tax cuts of EGTRRA will turn into Cinderella at midnight on December 31, 2010.²

Speaking in Cedar Rapids, Iowa in April, President Bush encouraged Congress to make the cuts permanent, "For the good of the working people in America, for the good of families, for the good of small businesses, for the good of farmers and ranchers, we need to make the tax relief plan permanent in the tax code." The House of Representatives responded in April by voting 229-to-198, mainly along party lines, to enact the Tax Relief Guarantee Bill of 2002 (H.R. 586) which would permanently extend the tax cuts. Practical Implications: The estate tax repeal and the other tax cuts arrived at a time when the economy was strong and tax revenues were creating, at least on paper, large future surpluses. Now, only a year later, the surplus mirages have vanished. The estimated cost of removing the sunset provision with respect to transfer taxes is $104 billion over the next 10 years and much more beyond ten years. As a result, passage in the Senate is by no means assured.

Although the deadline of midnight on December 31, 2010 is not imminent, people planning their wills and making other financial plans have numerous possibilities to take into consideration. Many in Congress would like to avoid the uncertainty of having these changes enacted under EGTRRA being potentially wiped out.

It may be cynical to say so, but regardless of whether the repeal is made permanent, this entire issue may be academic anyway. In the end, Congress will continue to have the ultimate say over whether the estate tax repeal phases in on schedule or is modified into some modified transfer tax system down the road. Social attitudes, economic health, and political factors will all have a role in the outcome. Moreover, we do not yet know all the implications of repeal or reinstatement of the estate tax. The Real Property, Probate and Trust Section of the American Bar Association has organized a task force of attorneys and professional organizations to prepare a written report to Congress to address the effect of the pending repeal of the estate tax or the manner of its reinstatement. As for the Byrd Rule, it continues to serve a purpose and will remain on the books, ready to confound the next tax reform that gets involved in budget legislation.³

TECHNICAL REFERENCES

² References to the 1974 Congressional Budget Act (CBA) and the Byrd Rule can be somewhat misleading. The Byrd Rule, which was added to the CBA in 1990, was named after its author, Senator Robert Byrd of West Virginia. Senator Byrd's tenure encompassed 1974 as well as 1990. Byrd was elected to the Senate in 1958. "In 2000, West Virginia voters elected me to an eighth consecutive six-year term in the Senate, making me the only person in the history of the Republic to achieve that milestone." -From Senator Byrd's website: http://www.senate.gov/~byrd/byrd_bio/byrd_story/byrd_story.html Under the Byrd rule, a Senator may object to any "extraneous" provision in a budget reconciliation bill. A provision is extraneous if it meets one of several definitions, such as a provision that would decrease revenues during a fiscal year after the fiscal years covered by such reconciliation bill. By including a sunset provision in EGTRRA, the bill avoided a point of order to remove such provisions unless 3/5ths of the Senate vote to waive the rule.

³ The Byrd Rule does not require a sunset provision-that was simply the course of action chosen to circumvent the Rule. But an expiration date for legislation does have its advantages. By imposing a built-in expiration date, provisions affecting future budgets must be revisited and affirmatively retained or they will be automatically swept off the books. In theory, a sunset approach would promote regular maintenance of legislation. In practice, sunset provisions add another level of uncertainty to an area of regulation that is already in constant change.

To Have, Yet Disclaim

Edward Walshire inherited a one-fourth interest in the real estate, stocks, bonds, bank accounts, and farm machinery that made up his brother's estate. Edward Walshire's children were the contingent beneficiaries under the terms of his brother's will.

Walshire's inheritance was converted to certificates of deposit (CDs) which he held as owner with his children listed as "pay on death" beneficiaries. Walshire received income from the CDs, but did not invade any of the principal. He executed a disclaimer of his remainder interests.

At Walshire's death, his executors excluded the CDs from his estate, reasoning that they were the remainder interests which had been disclaimed. The IRS found the disclaimer invalid and included the CDs in Walshire's estate and imposed taxes and penalties of $64,000.

The executors of the estate argued that §2518(a) permits "any interest" to be disclaimed and that a remainder interest should qualify as an "undivided interest" within the meaning of §2518(c). Therefore, a regulation not permitting an undivided remainder interest from qualifying for a disclaimer must be invalid.

Both the District Court and the Court of Appeals for the Eighth Circuit agreed with the IRS. The gift tax is interpreted broadly, to encompass all types of transfers, while disclaimers are interpreted narrowly, as an exception to the gift tax. Treasury Regulation §25.2518-3(b) prevents the disclaimer of a remainder interest, while retaining a life estate, from being considered a qualified disclaimer. This regulation was not found to be invalid as inharmonious with §2518.

"Walshire attempted to disclaim a portion of the property he was entitled to receive from his brother by dividing it horizontally," said the Court of Appeals, "that is, by disclaiming the remainder interest but retaining the right to the income and use of the property during his lifetime, or the life estate."

The regulation at issue in this case requires that the undivided portion "consist of a fraction or percentage of each and every substantial interest or right owned by the disclaimant in such property and must extend over the entire term of the disclaimant's interest in such property and in other property into which such property is converted. Treas. Reg. §25.2518-3(b)." Walshire, CA-8, 2002-1 USTC (May, 2002).

A Gift Pro Quo?

Powell made numerous gifts to charities, churches, family members and Ms. Young. At Christmas, he gave equal shares of stock to Young, his sister, and his wife. Having no children, he treated Young like a daughter and she continued to take care of his finances for him after his retirement with no expectation of compensation. She spent about two hours per week in these duties. However, Powell gave Young gifts of clothing, jewelry, perfume, candy, etc. throughout the year. And between 1988 and 1993, he gave Young year-end gifts totaling $798,250. His tax returns reported these transfers as gifts.

After Mr. Powell died in 1994, Mrs. Powell was advised to recharacterize the payments as compensation, but she declined to do so. Yet after Mrs. Powell's death in 1995, her executor pursued this tact and filed amended gift and income tax returns in which he failed to relate the crucial fact that Mr. Powell regarded the payments as gifts. The transferor's intentions are the most critical factor in determining whether a transfer "proceeds from a detached and disinterested generosity, . . . out of affection, respect, admiration, charity or like impulses."

Mr. Powell's gratitude toward Young for saving his fortune and his fatherly affection toward her were also clear evidence of his intent. "If something looks like a duck, walks like a duck, and talks like a duck," said the Appellate Court, "and the district court determines it to be a duck, it is not our place on review to call it something else."

Chief Judge Wilkinson concluded by distinguishing the motives that lead to transfers of assets: "It is a popular misconception that tax disputes are technical to the exclusion of all else. This case shows otherwise. Not every relationship in life may properly be characterized as involving `a mercenary exchange of good offices according to an agreed valuation.' Adam Smith, The Theory of Moral Sentiments pt. II, §II, ch. III, P 2 (1759). Not every human interaction is animated by a desire to secure an advantage, obtain compensation for services, or receive a quid pro quo. The district court found that Mr. Powell's relationship with Jane Young was much deeper than that. It is reassuring that the law does not permit appellant to tarnish the memory of their friendship by retroactively undoing the kindness they exhibited toward each other over many years." Post Script: The estate did not benefit by taking an appeal against the lower court's decision in this case. The lower court had dismissed a counterclaim filed by the United States against the estate as time barred. On appeal, the counterclaim (to recover income tax refunds issued for 1992 and 1993) was permitted because the executor of Mrs. Powell's estate had made grossly negligent misrepresentations that triggered an extended statue of limitations under §6532(b). Powell Est., CA-4, 2002-1 USTC (April, 2002).

Wrong Yet Justified?

The estate argued that §2210(a) discharged the executor in his representative capacity, and therefore discharged the estate. The government argued that §2210 merely discharged the executor's personal liability, and that the estate itself remained liable. In 1999, the District Court ruled in favor of the estate's position, and, finding the government's position unjustified, awarded attorney fees to the estate under §7430. Wilkes v. United States, 50 F. Supp. 2d 1281 (M.D. Fla. 1999).

On appeal, the Eleventh Circuit noted the context and found that as a matter of common experience, executors are not ordinarily held personally liable for estate tax. The statute's plain meaning, that the executor was relieved of liability, clearly referred to the executor in his representative capacity and unmistakably relieved the estate of liability. That was the whole point of §2210 and the estate tax strategies that were in use at that time. Sales to ESOPs were meant to reduce estate tax, not avoid executor liabilities! Nolan Wilkes, Sr. died in 1988, yet 14 years later, the matter of his estate's tax disputes could not be laid to rest without adding another chapter-another insult on top of the injury of taxes unfairly collected. The IRS was totally wrong, yet brought this last appeal to argue that it was "substantially justified." While the IRS may have a bona fide argument in some contexts that is worth asserting even when ultimately unsuccessful, in this context, "substantial justification" appears as oxymoronic as "uninvited guest," or "government organization." Held: It was not an abuse of discretion to award attorney fees. Wilkes, Jr. v. U.S., CA-11, 2002-1 USTC (April, 2002).

© R. Moshman