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Gift Taxes Included in Gross Estate

Estate Planning Journal

In Estate of Morgens, 1 the Tax Court held that the gift taxes paid by the donees of the income interest on account of the deemed transfer under Section 2519 of the remainder interest in a QTIP trust were included in the gross estate of the donor under Section 2035(b) because the donor died within three years of the gift taxes being paid.

Facts

Anne Morgens and James Morgens were married and resided in California. The Morgens executed a joint revocable trust. On Mr. Morgens' death, the assets of the joint revocable trust were divided into two separate trusts:

(1) The portion of the assets of the joint revocable trust representing Mrs. Morgens' one-half share of the community property of the couple was allocated to the survivor's trust.
(2) The portion of the assets of the joint revocable trust representing Mr. Morgens' one-half share of the community property of the couple was distributed to the residual trust.

A federal estate tax return was filed on behalf of the estate of Mr. Morgens, on which a marital deduction was claimed for the property passing to the residual trust.

The terms of the residual trust provided that Mrs. Morgens was entitled to receive the net income of the trust in quarter-annual or more frequent installments during her life. In addition, the trustees of the residual trust had the power to pay to or apply for the benefit of Mrs. Morgens as much of the principal of the trust as the trustees, in their discretion, considered necessary for Mrs. Morgens' proper support, health, and maintenance. The terms of the residual trust provided that on Mrs. Morgens' death, the remaining assets of the residual trust were to be divided among her children.

The remainder beneficiaries of the residual trust entered into an indemnification agreement with Mrs. Morgens and agreed to indemnify Mrs. Morgens for any gift or estate taxes that may be imposed as a result of Mrs. Morgens' gifts of her income interest in the residual trust to the remainder beneficiaries. In December 2000 and January 2001, Mrs. Morgens transferred her income interest in the residual trust to the remainder beneficiaries. These gifts were "net gifts" because the trustees of the residual trust paid the gift taxes associated with the transfers by Mrs. Morgens of her income interest in the residual trust and the gift taxes associated with her deemed transfers of the remainder interest in the residual trust pursuant to Section 2519. Gift tax returns were filed for 2000 and 2001 reporting Mrs. Morgens' gifts of her income interest in the residual trust and her deemed gifts of the remainder interest in the residual trust pursuant to Section 2519.

Mrs. Morgens died in August 2002. The federal estate tax return for Mrs. Morgens did not include in her gross estate the gift taxes paid by the trustees of the residual trust with respect to the 2000 and 2001 deemed transfers of the remainder interest in the residual trust. The executors excluded those gift taxes from the gross estate on the basis that the gift taxes were not paid by Mrs. Morgens or her spouse within three years of Mrs. Morgens' death. The IRS audited the estate tax return and issued a notice of deficiency including those gift taxes in Mrs. Morgens' gross estate.

Analysis

• Section 2035(b) provides that the gross estate includes any gift tax paid by the decedent or the decedent's estate on any gift made by the decedent or his or her spouse during the three-year period preceding the decedent's death.
• Section 2519 treats any disposition of all or part of the income interest in QTIP as a transfer of all interests in QTIP including the remainder interest in QTIP. 2
• Section 2207A(b) provides that if a gift tax is due on the deemed transfer of QTIP, then the surviving spouse is allowed to recover the gift taxes paid from the recipients of the QTIP. 3 The IRS argued that Mrs. Morgens was liable for the gift tax liability attributable to the 2000 and 2001 deemed transfers by Mrs. Morgens of her remainder interest in the residual trust and that Section 2207A(b) does not shift her liability to the trustees of the residual trust. The estate contended that applying Section 2035(b) to the gift taxes paid by the trustees of the residual trust with respect to the 2000 and 2001 deemed transfers by Mrs. Morgens was contrary to Section 2207A(b). The court did not agree with the estate and held in favor of the IRS. The court began its analysis by noting that the quid pro quo for allowing a marital deduction in the estate of the first spouse to die is that such property must be included in the gross estate of the surviving spouse at his or her death under Section 2044(a) or subject to gift tax on a lifetime disposition of his or her income interest in the property under Sections 2511(a) and 2519. The court held that Sections 2044 and 2519 treat the surviving spouse as if he or she owned the QTIP outright. The court therefore held that for purposes of the Code, Mrs. Morgens was the donor of the income interest and the remainder interest in the residual trust. The court continued its analysis by stating that as the donor of the income interest and the deemed donor of the remainder interest in the residual trust, Mrs. Morgens bears the gift tax liability associated with the transfer of those interests. Next the court addressed the estate's argument that Section 2207A(b) shifts that liability from Mrs. Morgens to the recipients of the income interest in the residual trust. Section 2207A(b) provides that if any gift taxes are paid by the deemed transferor under Section 2519, the deemed transferor is entitled to recover such gift taxes paid from the persons receiving the income interest. The court agreed with the estate that the recipients of the income interest, as opposed to Mrs. Morgens, bear the ultimate financial burden for the gift taxes paid as a result of the deemed transfer under Section 2519. The court stated, however, that it did not believe that by shifting the financial burden to the recipients of the income interest, Congress had intended to shift to them the liability for the gift taxes due. The court stated that Section 2207A(b) does not provide that the donees of the income interest should be liable for the gift taxes. Rather, the court stated that Section 2207A(b) provides the transferor with a right to recover gift taxes paid from the recipients of the income interest. In support of its holding, the court noted that Section 2502(c) provides that the gift taxes are to be paid by the donor. The court recognized that while taxpayers may allocate the burden of the gift tax between themselves, that allocation does not shift the liability for purposes of the Code. Having decided that Mrs. Morgens was liable for the gift tax due as a result of her deemed transfer and that Section 2207(b) did not shift that liability to the donees, the court considered whether Section 2035(b) would require the gift taxes paid to be included in Mrs. Morgens' gross estate. Section 2035(b) provides that the gross estate includes any gift tax paid by the decedent or his or her estate on any gift made by the decedent or his or her spouse during the three-year period preceding the decedent's death. The court began its analysis by considering previously decided cases involving Section 2035(b) in the context of "net gifts." A net gift is a gift made by the donor subject to the condition that the donee pays the resulting gift tax. In the context of net gifts, in calculating the gift tax, the donor reduces the gift by the gift taxes due. In Estate of Sachs, 4 the decedent made gifts of stock to trusts established for the benefit of his children on the condition that the trustees pay the resulting gift taxes. The decedent reported the gifts as net gifts. Because the decedent died within three years of the gifts, the IRS included the gift taxes paid by the trusts in the decedent's gross estate under Section 2035(b). The court in Sachs held that the phrase "gift tax paid by the decedent or his estate" in Section 2035(b) included the gift tax attributable to net gifts made by the decedent during the three-year period before his or her death, even though the donees were contractually obligated to pay the gift taxes. The court concluded that this case was similar to Sachs because the trustees of the residual trust had a contractual obligation to indemnify Mrs. Morgens for any gift tax liability. The court, therefore, concluded that the gift taxes paid by the trustees of the residual trust as a result of Mrs. Morgens' deemed transfer of the remainder interest in the residual trust pursuant to Section 2519 were required to be included in her gross estate under Section 2035(b). Comments This case reminds estate planners to consider the impact of Section 2035(b) when advising clients regarding gifts and net gifts that result in significant gift taxes being due. The case appears to have been correctly decided. 1 133 TC No 17, Tax Ct Rep (CCH) 58027, Tax Ct Rep Dec (RIA) 133.17, 2009 WL 4980468 . 2 The surviving spouse determines the gift tax consequences of the disposition of the income interest separately under Section 2511(a). 3 Reg. 25.2707A-1(e) provides that if the QTIP property is in a trust at the time of the transfer, the person receiving the property is deemed to be the trustee. 4 88 TC 769 (1987), aff'd in part and rev'd in part on another ground 62 AFTR 2d 88- 6000, 856 F2d 1158, 88-2 USTC 13781 (CA-8, 1988).

 

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