More On Tax Planningfrom The Advisor's Professional Library
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
In the gift tax arena, the value assigned to the transferred property can often make or break your high-net-worth clients’ tax planning strategies, leading many clients to move conservatively through the valuation minefield.
Despite this, the newest strategy to emerge in the world of gift tax valuation can actually allow these wealthy clients to reduce their estate tax liability. Reversing course from a previous line of cases, the Tax Court recently blessed a cutting edge valuation strategy for lifetime gifts that can be used to reduce overall estate tax liability for these clients by simultaneously reducing the bite of the often-overlooked three-year bringback rule—a rule which can cause even the most carefully laid estate plans to fail.
The Three-Year Bringback Rule
Under the three-year bringback rule of IRC Section 2035, the value of a decedent’s gross estate is increased by the amount of any gift taxes paid by the decedent or the decedent’s estate on any gifts made within the three-year period prior to death. The purpose of this rule is to discourage taxpayers from making deathbed transfers that would remove the value of the gift tax liability from the estate.
Unfortunately, this rule can nullify the utility of an estate plan that hinges upon the making of lifetime gifts to family or friends in order to reduce the eventual size of the taxable estate. The eventual estate taxes that could result would offset the value of the gift taxes that were removed from the estate. Even more importantly, because your clients cannot accurately predict how long they will live, the rule can take many clients completely by surprise.
Steinberg: The Facts
The taxpayer in Steinberg vs. Commissioner sought to avoid this result by providing that the value of lifetime gifts made to her children would be reduced by any estate taxes imposed under the three-year rule through an agreement under which the recipients actually assumed responsibility for these potential estate taxes.
In this case, the taxpayer was a wealthy 89-year-old woman who made substantial lifetime gifts to her four daughters. Because her age made the possibility of reversion under the three-year rule very likely, the family negotiated a complex agreement pursuant to which the donees agree to pay not only the gift tax on the gifts but also any estate tax liability that would accrue should the taxpayer die within three years of making the gifts. If any donee failed to satisfy her obligations under the agreement, all other distributions that she might otherwise be entitled to receive from the estate would revert back to the estate.
Pursuant to the agreement, an appraiser was hired to determine the value of the net gift, which was the fair market value of the gift reduced by the gift taxes paid and the actuarial value of the potential liability under the three-year rule assumed by each donee.
Despite the fact that the potential estate tax liability was computed using a formula that considered the probability that the taxpayer would die within each of the three years following the gift (based on her age and IRS mortality tables), the IRS argued that the value of the gifts could not be reduced because the assumption of liability provided no concrete benefit to the taxpayer. Noting that the value could not be accurately determined using this method, the IRS found that the assumption of liability provided nothing but unquantifiable peace of mind to the taxpayer.
The Tax Court disagreed, finding that the value of the donees’ assumption of the potential estate tax liability could be determined in this manner and that the taxpayer had intended to reduce the value of the gifts by the amount of any estate tax liability assumed at the time the gifts were made.
The use of lifetime gifts can play a powerful role in your clients’ estate planning strategies, and any high net worth taxpayer who wishes to make large lifetime gifts in order to reduce the taxable estate should be made aware of this strategy for potentially mitigating the nullifying impact of the three-year bringback rule.