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How one family fought the IRS on estate taxes — and won

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There wouldn’t seem to be a whole lot of loopholes available for people making use of the gift tax exemption to reduce their estate taxes. But that doesn’t stop people from trying to invent ways around it.

One such person was Jean Steinberg, a very wealthy 89-year-old woman with four daughters. She gave the daughters a $72 million gift of cash and securities, which, needless to say, was well over the gift tax limit. But she came up with a strategy to reduce the value of that gift — and thereby reduce the taxes on them.

The strategy hinged on the three-year rule, which tries to keep people from giving away property just prior to their death in order to keep it out of their estate. If Steinberg had passed away within three years of making the gift, the assets would revert to her estate, and the estate would owe tax on it. In order to keep her estate tax from paying the full rate on that amount, Steinberg asked her daughters to take the full responsibility for it if she should pass away within three years.

Steinberg’s daughters agreed to assume any gift or estate taxes that would result if she passed away within three years of making the gift. She then made the claim that the value of their gift should be reduced by the amount that would revert back to the estate in case of their mother’s death.

The gift had been drawn up very carefully. If the daughters did not agree to cover the estate taxes, they wouldn’t be eligible for any further distributions from the estate. Therefore, Steinberg argued, the gift was contingent on the payment of those taxes and should be reduced by their value. And since Steinberg was 89 at the time, there was a good chance she wouldn’t make it through that three-year window.

See also: 3 ways to reduce your clients’ lifetime tax burden

The IRS, of course, disputed that interpretation of events. An auditor claimed the tactic used by the Steinbergs didn’t really affect the value of Mrs. Steinberg’s estate. The resulting understatement of gift tax, according to the IRS, was $1.8 million.

But Steinberg, who had hung in there and was still alive, fought the IRS ruling. Earlier this month, the tax court decided in her favor. It ruled that the increased tax burden the daughters took on did indeed count as a reduction for the value of the net gift.

The Steinbergs trotted out actuarial tables, showing how much longer Mrs. Steinberg was likely to live and, thus, how likely it was the three-year rule would be in effect. From all that data, they constructed a real-world value for the value of the gifts. The tax court found those figures plausible and ruled in favor of the Steinbergs.

The takeaway

There are two basic lessons from all this. First of all, the IRS often seems to be an impregnable fortress, impervious to any challenges from taxpayers. In this case, it made what seemed to be a reasonable ruling, not even much of an overreach. Yet in tax court, that ruling was nullified.

Secondly, it highlights the three-year rule, which is an oft-overlooked part of estate planning. The gift tax obviates much of the rationale behind the three-year rule, since the recipient is likely to owe gift tax on anything that would end up making much of a dent in someone’s estate.

Nevertheless, clients nearing death should be aware that they can’t save money for their heirs by giving away sizable chunks of their estate. It’s not just the gifts that will revert back to the estate but any gift taxes as well. In that sense, it doesn’t pay to try to outsmart the IRS.

The Steinberg ruling was highly technical, as these things tend to be. Anyone wishing to make use of the ruling should review the legal findings in the case, which can be found here.

For more on estate planning, see:

5 tips for digital estate planning

How to avoid the transfer for value tax trap

How to determine the fair market value of a gift