POP QUIZ - FLORIDA APPORTIONMENT

BACKGROUND FACTS:

Decedent dies, and his estate is subject to federal estate taxes. Part of his taxable estate assets pass under his Last Will and through his probate estate, and part of the assets consist of life insurance that passes outside of the probate estate. Thus, part of the federal estate taxes are attributable to the life insurance.

Florida law provides that the default allocation and apportionment of estate taxes is that the recipient of insurance and other nonprobate assets pay their share of the estate taxes attributable to those nonprobate assets, absent a proper allocation of those taxes to probate property.

The decedent's Last Will provides:

"I direct my Personal Representative TO PAY OUT OF THE property which would otherwise become a part of the RESIDUARY ESTATE, ALL ESTATE, inheritance, transfer and succession TAXES, including interest and penalties thereon, WHICH MAY BE LAWFULLY ASSESSED BY REASON OF MY DEATH. I WAIVE on behalf of my estate ANY RIGHT TO RECOVER any part of SUCH TAXES, interest or penalties FROM any person, including ANY BENEFICIARY OF INSURANCE on my life and anyone who may have received from me or from my estate any property which is taxable as part of my estate." (emphasis added)

Fla.Stats. § 733.817(5)(h)(4), relating to when a direction in a Last Will to pay taxes on nonprobate property from probate property will be respected, provides:

"For a direction in a governing instrument to be effective to direct payment of taxes attributable to property not passing under the governing instrument from property passing under the governing instrument, the governing instrument must expressly refer to this section, or expressly indicate that the property passing under the governing instrument is to bear the burden of taxation for property not passing under the governing instrument. A direction in the governing instrument to the effect that all taxes are to be paid from property passing under the governing instrument whether attributable to property passing under the governing instrument or otherwise shall be effective to direct the payment from property passing under the governing instrument of taxes attributable to property not passing under the governing instrument."

THE QUESTION:

Does the insurance in the decedent's estate bear estate taxes, or will the insurance beneficiaries receive the proceeds tax-free while the probate estate and its beneficiaries have to pay the estate taxes attributable to the insurance?

THE ANSWER:

According to the recently decided appellate case of Boulis v. Estate of Boulis, 34 Fla.L.Weekly D1567b, (4th DCA, August 5, 2009), the tax apportionment clause is NOT effective to shift the taxation of the insurance proceeds to the probate estate, so the insurance beneficiaries will have to bear their share of the estate taxes.

Doesn't the apportionment clause in the Last Will direct to "pay out of the residuary estate...all estate taxes?" Yes, it does. But per Fla.Stats. § 733.817(5)(h)(4), for such a direction to be effective, such a direction must either refer to that section of the law (which was not done in the Last Will), or "expressly indicate that the property passing under the governing instrument is to bear the burden of taxation for property not passing under the governing instrument."

To the appellate court, a direct expression to pay all estate taxes out of the probate estate is not the same as the requisite direct expression to have nonprobate property bear the burden of the estate taxes. Presumably, some direct reference to "nonprobate property" is needed. But wasn't there such a reference when the Last Will expressly provides that the estate waived any right to recover estate taxes from insurance beneficiaries?

Did you get the answer right? Don't be upset if you didn't - reasonable minds clearly will differ on whether the appellate court was correct on this one.

LESSONS TO BE LEARNED:

Don't mess around with apportionment. If you want to have estate taxes paid by the probate estate on nonprobate assets, stick closely to the statutory language. This means either make a direct reference to Fla.Stats. § 733.817(5)(h)(4), or use the "safe harbor" language in that statute ("all taxes are to be paid from property passing under the governing instrument whether attributable to property passing under the governing instrument or otherwise") or something very close to it.

BASIS OVERSTATEMENT DOES NOT TRIGGER 6 YEAR STATUTE OF LIMITATIONS

Under the Internal Revenue Code, the statute of limitations imposed on the IRS for assessing additional income tax is 3 years after the later of the date the tax return was filed or the due date of the tax return. However, a 6-year period of limitations applies when a taxpayer omits from gross income an amount that's greater than 25% of the amount of gross income stated in the return.

In a recent case before the Court of Appeals for the Federal Circuit, the taxpayer had overstated its adjusted basis in reporting gain from a disposition of property. This overstatement of basis resulted in less gain being reported then was determined to be due. The issue before the Court was whether an understatement of gain relating to an overstatement of basis is an "omission from gross income" giving rise to the extended 6-year period of limitations. Similar rules apply in regard to partnership audits, which rules applied in this case.

Reversing the Court of Claims, the Court of Appeals held that the 6-year statute of limitations did not apply. The Court relied on the U.S. Supreme Court case of Colony Inc. v. Comm., 357 US 28 (1958) wherein the U.S. Supreme Court had indicated that the statutory language refers to the specific situation where a taxpayer actually omitted some income receipt or accrual in his computation of gross income, and not more generally to errors in that computation arising from other causes.

The Ninth Circuit Court of Appeals ruled similarly in 2009, so the IRS will likely have to concede this point in the future.

Salman Ranch Ltd. et al. v. U.S., 104 AFTR 2d ¶ 2009-5190 (CA FC 7/30/2009)

DISCOUNTING VOIDED VIA STEP TRANSACTION DOCTRINE

Oftentimes, taxpayers contribute assets to partnerships or LLCs, and then make a gift of ownership interests in the partnership or LLC and seek to apply a valuation discount to the gift. A recent District Court case voided the application of the discounts through the use of the step transaction doctrine.

In the case, there was some uncertainty whether the gift of interests in an LLC occurred simultaneously with the contribution of assets to the LLC, or sometime after. Nonetheless, the court addressed what result would occur even if the funding to the LLC occurred prior to the gift of LLC interests.

The court noted that there are three different tests under which the step transaction can be applied. The binding commitment test, which is the narrowest alternative, collapses a series of transactions into one “if, at the time the first step is entered into, there was a binding commitment to undertake the later step.” The end result test stands at the other extreme and is the most flexible standard, asking whether the “series of formally separate steps are really pre-arranged parts of a single transaction intended from the outset to reach the ultimate result.” The interdependence test inquires whether, “on a reasonable interpretation of objective facts,” the steps were “so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series” of transactions. The interdependence test focuses on the relationships between the steps, rather than on their end result. The question is whether “any one step would have been undertaken except in contemplation of the other integrating acts.”

The court found that the transaction flunked all three tests under the facts of the case. By applying the step transaction doctrine, the court determined that the assets contributed to the LLC were an indirect gift to the recipients of the LLC interest gifts, and thus not entitled to a valuation discount based on LLC attributes.

In discussing similar cases where the step transaction was NOT applied, the court provided guidance for avoiding its application. The court noted in those other cases (Holman v. Comm'r, 130 T.C. 170 (2008); Gross v. Comm'r, 96 T.C.M. (CCH) 187, 2008 [TC Memo 2008-221] WL 4388277 (2008)) the assets contributed to the entity had the potential to materially fluctuate in value prior to the subsequent gifting of the interests in the entity. Also, in those other cases, the donor/contributor had made an affirmative and clear decision to delay the gifting of the interests until some time after the contribution of assets to the entity (even though the delay was only a few days). Practitioners seeking to avoid the application of the step transaction doctrine should be mindful of these types of facts.

Linton v. U.S., 104 AFTR 2d 2009-5176, 07/01/2009