by Jon J. Gallo, J.D.
Jon J. Gallo, J.D., chairs the Family Wealth Practice Group of Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their website is www.galloconsulting.com.
Kite v. Comm’r, T.C. Memo 2013-43, illustrates both the potential tax savings possible through the use of deferred private annuities and the difficulties posed by one of the more arcane provisions of the gift tax laws. Kite’s conclusion that Section 2519 of the Internal Revenue Code applied to the private annuity transaction appears to be bad law that creates unnecessary doubt and confusion when planning for distributions from Qualified Terminable Interest Property (QTIP) trusts.
The decision devotes 18 pages to describing the complex facts. What follows is a Cliff’s Notes version of the facts. At the time involved, Virginia Kite was 74 years old. She was a successful and sophisticated business woman of substantial wealth, partly as the result of being the beneficiary of several trusts established by her father, the chairman of a family owned bank. She was a widow and the beneficiary of several QTIP marital deduction trusts. She also owned substantial assets through her own revocable trust.
The QTIP trusts and Kite’s revocable trust collectively owned approximately $12.5 million in secured, fully recourse promissory notes. On January 18, 2001, the family attorney met with the Kite children to propose a deferred private annuity, pursuant to which the three children would acquire the promissory notes in exchange for three unsecured annuity agreements, under which each child promised to pay approximately $1.9 million to Kite on March 30 of each year, beginning in 2011 and ending on her death. According to the Tax Court, if Kite survived for 13 years or longer, her children could be insolvent in view of their then personal assets, but those assets obviously would be increased by the value of the assets they would acquire.
Kite agreed to the transaction after being assured that she would have sufficient other assets and income to maintain her lifestyle during the 10-year period before the annuity began. She also contacted her physician, who sent a letter stating that in his opinion she was not terminally ill, nor did she have any illness or physical condition that would cause her to die within one year. He estimated a 50 percent probability that she would live 18 months or longer. The physician was not called to testify at trial.
On March 28, 2001, Kite removed the corporate trustee of the QTIP trusts and replaced it with her three children. The children terminated the QTIP trusts and distributed the assets (which consisted solely of KIC general partnership interests) to Kite. Two days later, on March 30, Kite entered into the private annuity transaction. She died April 28, 2004, before receiving any payments on the deferred annuity. Her estate tax return did not include the deferred annuity in her gross estate. On audit, the IRS issued two notices of deficiency, one for approximately $6 million in gift tax for 2001, and one for $5.1 million in estate tax.
The Service argued that the deferred private annuity was a disguised gift because there was no real expectation of payment. The crux of the Service’s argument was that it was improper to use the actuarial tables under IRC Section 7520 because Kite’s health in 2001 made her death within 10 years foreseeable. The Tax Court pointed out that the Service, as the party seeking to depart from the actuarial tables, bore the burden of proving that the circumstances justified such a departure. This presented the IRS with a bit of a problem because according to the IRS’s own actuarial tables in 2001, a 75-year-old woman without a terminal illness was expected to live 12.5 years, which was 2.5 years after the first annuity payment was due.
Under Section 1.7520-3(b)(3) of the regulations, the mortality component of the annuity tables is not applicable only if the measuring life is terminally ill at the time of the transaction. A terminal illness is defined as an “incurable illness or other deteriorating physical condition” with at least a 50 percent chance of death within a year. Based on the physician’s letter, which the Service failed to challenge, Kite had at least a 50 percent probability of surviving for 18 months or longer. As a result, the court found that the use of the IRC 7520 annuity tables was justified and that Kite accordingly received adequate and full consideration for the transfer.
The Tax Court further dismissed the argument that the annuity transaction was illusory. The court pointed out that the agreement between Kite and her children was enforceable and that the children demonstrated their intention to comply with the agreement by such actions as not making any distributions from KIC, but rather allowed the assets to accumulate “in order to have the income available when the annuity payments became due.” As a result, the Tax Court did not uphold the Service’s $5.1 million estate tax deficiency.
Private Annuities and Taxable Gifts
Kite is an excellent primer for the planner who is considering a private annuity transaction. The problem with Kite arises when the Tax Court discusses the alternative argument by the Service that the annuity transaction constituted a disposition of Kite’s qualifying income interests for life, which she held in the various QTIP trusts, and that such disposition constituted taxable gifts under IRC Section 2519.
Essentially, the Service argued that the termination of the QTIP trusts and the annuity transaction should be viewed as an integrated transaction in which Kite disposed of her income interest in the QTIP trusts in exchange for the deferred annuity. The Tax Court agreed, apparently troubled by the fact that the deferred annuity resulted in no estate tax inclusion, and upheld the $6 million gift tax deficiency.
Here’s the issue: IRC Section 2056(a) creates the federal estate tax marital deduction by providing that an estate may deduct the value of any interest passing from the decedent to a surviving spouse. The tax policy behind the marital deduction is to defer the taxation of marital property when the predeceased spouse leaves property to the surviving spouse in a manner that will subject it to estate tax at the surviving spouse’s death. No marital deduction is generally allowed if the interest passing to the surviving spouse is a “terminable interest,” such as a life estate that terminates at the death of the life tenant, leaving nothing in the life tenant’s estate that could be subject to estate tax.
In 1981 Congress added subsection (b)(7) to Section 2056. This new subsection allowed a marital deduction for a “qualifying interest” passing to a surviving spouse, such as a life estate, provided the executor of the estate of the deceased spouse lists the interest on the deceased spouse’s estate tax return and identifies it as a QTIP. Property identified as a QTIP will be subject to estate tax at the surviving spouse’s death, even if it is an otherwise non-qualifying terminable interest.
Because a life estate vanishes at the death of the life tenant, Congress was justifiably concerned that an opportunity for improper tax avoidance existed if the surviving spouse disposed of his or her “qualifying interest” during lifetime. To deal with this problem, IRC Section 2519 provides that if the surviving spouse disposes of a qualifying interest during lifetime, such disposition is treated as a taxable gift by the surviving spouse of the remainder interest in the QTIP property.
The regulations illustrate this concept by assuming that the surviving spouse is given a life estate in a personal residence valued at $250,000, and after the surviving spouse’s death, the residence passes to the decedent’s children. At a time when the value of the residence is $300,000 and the surviving spouse’s life estate is worth $100,000, the surviving spouse sells her life interest to the children for $100,000. The sale of the life estate is a “disposition” and the survivor is treated as having made a gift of the remainder interest (then worth $200,000) because that asset will not be included in her gross estate at her death.
A Questionable Conclusion
The Tax Court’s conclusion that Kite should be treated as having made a taxable gift of the remainder interest in the QTIP trusts when she exchanged the notes for the deferred annuity is highly questionable, if not downright wrong, for two reasons.
First, the Tax Court essentially ignored the termination of the QTIP trusts to treat the transaction as a disposition of Kite’s qualified income interest in those trusts. Doing so casts the transaction as a sale by the QTIP trusts of the promissory notes in exchange for the deferred private annuity. Under such circumstances, no disposition of Kite’s qualifying interest would have occurred, because Regulation 25.2519-1(f) provides that the sale and reinvestment of assets of a trust holding qualified terminable interest property is not a disposition. The QTIP trusts would be viewed as selling the notes and reinvesting in the private annuity—and that is not a disposition. If such a sale by the QTIP trusts is not a disposition, the same sale by Kite should not be a disposition.
Second, the Tax Court disregarded its own finding that the private annuity was entered into for full and adequate consideration equal to the fair market value of the KIC interests and not simply the fair market value of Kite’s qualifying interest. As a result, the decision could result in double taxation in similar situations. Assume that Kite did not enter into the deferred private annuity but rather sold the notes to her children for full and adequate consideration and purchased publicly traded securities. Under Kite, the termination of the QTIP trusts followed by the sale of the notes would be a disposition of her qualifying interest that was subject to gift tax under IRC Section 2519. However, the publicly traded securities would be included in her estate under IRC Section 2031 with apparently no offset or credit for such gift taxes!
We can only hope that the Tax Court will reconsider its analysis of the applicability of IRC 2519 to terminations of QTIP trusts. Until then, Kite creates substantial unneeded confusion for planners contemplating the distribution of principal of a QTIP trust to a surviving spouse if such spouse might subsequently transfer the principal to the remainder beneficiaries by sale or gift.