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Estate Planning: The Wrong Way With Minimum Effect

THE HISTORY:

Roger and Mary Hunt, husband and wife, lived for many years in Carroll County, Tennessee with their only child Sue, where Roger operated a construction company with Sue assisting him in the operation of the business. During their lives together, the couple was able to amass a small estate of jointly held assets. Roger died intestate on October 5, 1983 leaving Mary the task of settling his estate. In an effort to make things easier on Sue, early in the 2000’s, Mary decided to put Sue’s name on all of her bank accounts, including her certificates of deposit using the payable on death designation to make the monies more accessible. This activity could have produced a gift tax liability; however there was not a completion of a gift because Sue never used any of the monies for her own benefit.

During this same time period Sue and her husband, who was a building contractor, built a home on land owned by Mary and also built some income producing structures on other land owned by Mary. The question of a completed gift comes into play with these transactions because there never were any arms-length transactions that took place and none of the income produced was paid to Mary.

Seeing possible estate tax problems, Sue talked her mother into gifting part of the real property to her, her husband and four daughters. Sue, being a fairly intelligent woman, utilizing her knowledge of tax law, starting in 2005 and continuing through 2008, personally prepared transfer deeds on certain tracts of realty owned by her mother in an effort to remove them from her mother’s estate.

Mary died on April 27, 2009 leaving her daughter to settle the affairs of her estate, without realizing the compound problems that had already started due to the inability to properly establish a formal estate plan. The case below will detail the activity that took place in trying to pass this estate down to the heirs.

THE CASE:

1985:
In settling the estate of her deceased husband, Mary utilized a local attorney to help her prepare Form 706 United States Estate Tax Return and filed it on June 27, 1984. The estate consisted of eleven different parcels of real estate, which was valued on the estate tax return without and evidence of value (appraisal), cash and miscellaneous assets. The realty was valued at $158,150, cash and near cash items at $136,620 and other miscellaneous property was $28,019. The valued reported on these items indicated a total gross estate of $322,789. Total allowable deductions for the estate consisted of funeral expenses, miscellaneous taxes, probate costs and debts of the decedent equaling $18,075 making the taxable estate $304,714 and using the 1983 tax rates the estate tax on this amount was $89,403 which after the application of the unified credit of $79,300 left a tax due of $10,103 ($6,352 federal and $3,751).

2005:
The gifting program started with Sue using the records from the county assessor’s office to value the gifts of realty, placing a value on the real estate below the $11,000 per donee limit, without getting a qualified appraisal done on the properties. Transaction number one for 2005 was the gift of one acre to her and her husband and their four daughters. Actual appraised value was $40,000. Transaction number two for 2005 was the gift of 13 acres to her, her husband and four daughters with the actual appraised value of $32,000. Total gifts for this year were $72,000 less the annual exclusion of $48,666 ($22,000 for Sue and husband and $26,666 for the four daughters which was a generation skipping tax item subject to $1,500,000 exclusion. This left a taxable gift for 2005 in the amount of $23,334 with a tax liability of $4,533. Using the unified credit reduced the 2005 taxes to zero. So far, so good!

2006:
The annual gift tax exclusion for 2006 was $12,000 per donee, and according to past history, Sue again made gifts of real estate using the same methods as she did in 2005. The gift for this period was one tract with a commercial building on it with appraised value of $105,000. The annual exclusion was $72,000 leaving a taxable gift of $33,000 for the year with an associated tax liability of $7,587 which was again eliminated by the unified credit. So far, so good!

2007:
Should things be any different for 2007? Not really, just a little more complicated. Mary owned 192 acres with Sue jointly and Sue owned 50 acres of the same tract individually. The transfer was to Sue and her four daughters of the 192 acres and the 50% of the 50 acres held jointly with her mother. Again, it was assumed the value of this transfer was below the limit for gift tax purposes, but in fact the value was $187,500.

The total taxable gifts for 2007 were $127,500 with tax liability of $49,627. Thank goodness for the unified credit eliminating the tax liability again. So far, so good!

2008:
The year 2008 brought about more gifts. The acre tract where Sue and her husband built their home was about to get deeded to them. This amount would have passed the annual exclusion test except there were other transfers the same year. Two more tracts were deeded to Sue, her husband and their four daughters making the gifts for 2008 total $109,000 at appraised values. The taxable estate and the corresponding tax liability were $37,000 and $11,840, respectively. Again the unified credit wiped out the tax liability. So far, so good!

2009:
Mary died testate on April 27, 2009 leaving her only child Sue to settle the estate. Her gross estate consisted of $1,090,000 appraised value of real estate, $343,673 in cash and near cash items, $5,262 in life insurance and $10.000 in household effects for a grand total gross estate value of $1,448,935 less the allowable deductions for funeral expenses and debts of $64,738 left a tentative taxable estate of $$1,384,557 which carried a tax liability of $617,549 ($591.507 federal and $26,042 state). Using the remainder of the unified credit this amount was reduced to zero. So far, so good!

Well, not really because now we have to deal with the State of Tennessee. Gift tax returns should have been filed for the years 2005 through 2008 and taxes paid on the amounts of the taxable gifts for each year. In addition to the tax, there were penalties and interest due on the delinquent returns. The total of all taxes, penalties and interest for the years in this case were $2,111; $2,775; $11,098; $2,667 for the years 2005 through 2008, respectively. The grand total of state gift taxes including penalties and interest was $28,651. The Tennessee inheritance tax return was timely filed with a total tax liability of $26,042. A shocking grand total paid to the state of Tennessee for Mary’s estate including the gift taxes was $54,693.

Also, in addition to the total gift and inheritance taxes paid by Mary’s estate were appraisal fees, surveying fees, legal and accounting fees that cost a little more than $35,000. These fees could have been mitigated somewhat had appraisals not been required for dual years (date of gift and date of death) by having the work done on the gifted property in the years the gifts were made and own the property still held at death on that date.

THE PROBLEMS:

The Form 706 United States Estate Tax Return for the estate of Roger Hunt appears to have some errors on it. If Roger and Mary were in fact husband and wife and held the property jointly, Mary should have been able to take the property utilizing the unlimited marital deduction. Had she wanted to sell the property then she may have forgone this election and taken a stepped up basis on the half interest owned by Roger, but since she did not sell the property it is evident that she did not need to waive the deduction, however, since the statutes of limitations has run on this return there is little that can be accomplished. Had the unlimited marital deduction been taken the estate would not have had to pay the $10,103 taxes to the Internal Revenue Service and the State of Tennessee.

Another probable mistake made on the filing of the 706 was the valuation of the real property that passed through the estate. The taxpayer should be aware of what constitutes value of property and should be guided by the Internal Revenue Service’s definition “Under Regs. 20.2031-1(b) (estate tax) and 20.2512-1 (b) (gift tax), the definition of fair market value is ‘the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the facts.’(“Gift and Estate Tax Valuation”, Lance S. Hall, Valuation Strategies, Boston: Jan/Feb 2006, Vol. 9, Iss. 3 pg. 39) “Family real estate holdings typically have substantial financial value…Often, they were assembled over a long period of time at relatively low cost and comprise substantial acreage” (“Estate Planning For Major Family Real Estate Holdings”, James S. Sligar, Trusts & Estates, Dec 1994; 133, 12, pg 48.) There are two methods use to establish value for the estate, but both have to satisfy the scrutiny of the Internal Revenue Service. Either method may be attached to the estate or gift tax return and include “a qualified appraisal; or a detailed description of the method used to determine the fair market value (FMV) of the property transferred” (“Gift Tax Nightmares”, Lorelei Tolson, Trust & Estates, New York; July 2008 Vol. 137, Iss. 7; page 59) In order to arrive at this “price” it should be evident that an opinion of value should be rendered by a qualified real estate appraiser because the lack of this due diligence could continue to plague the family for years to come.

The most obvious problems in this case occurred because of the gifting and the valuation put on the gifts. “The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.” (“New Problems for the Unwary in Estate and Gift Tax Valuations: Penalties Under I.R.C. 6660”, Martha S. Scheer and Edward J. Gac, Accounting Horizons; Dec 1987; 1, 4, pg 69). Gifts transferred within three years of death will be part of the estate of the decedent according to Internal Revenue Service regulations. A completed gift is consummated by the “acceptance of the gift by a donee who has the unrestricted right to the immediate use, possession or enjoyment of the property.” (“Incomplete Gifts”, Michael Lynch, Journal of Accountancy, New York: Jan 1999. Vol 187 Iss. 1; pg 74). (This brings back to mind the concept of gifting of land where the house and commercial property were built). Also, inherent in the gifting were timing issues as well as the amount of the gifts.

THE CURE:

Due to the length of time and the statutes of limitations, the estate tax return for Roger Hunt, cannot be amended to correct the error for the unlimited marital deduction. Then end result for this return is the Hunt family paid $10,103 in unneeded taxes.

The gift tax returns for the years 2005 through 2008 had to be filed because it was the intent of the family to make the gifts. The errors the made was not starting the gifting program sooner and utilizing a split gift for only partial tracts of land that would have been appraised below the gift tax limitation. One thing in the favor of the Hunt’s was that the unified credit amount was more than able to offset any federal gift taxes and estate taxes. The only problem they had was settling with the State of Tennessee which required gift tax returns to be filed and paid and since they were not timely filed penalties and interest accrued. The limit for the unified credit for the state was $1,000,000 and therefore created the inheritance tax liability.

THE CONCLUSION:

Had the Hunt’s used adequate estate tax professionals and not relied on self taught knowledge and with a little estate planning that should have started in 1983, with the death of Mr. Hunt, then they should have been able to shelter this entire estate and saved the family $64,796 plus at least $20,000 in service fees.

REFERENCES

  • Gift and Estate Tax Valuation”, Lance S. Hall, Valuation Strategies, Boston: Jan/Feb 2006, Vol. 9, Iss. 3 pg. 39
  • Estate Planning For Major Family Real Estate Holdings”, James S. Sligar, Trusts & Estates, Dec 1994; 133, 12, pg 48
  • Gift Tax Nightmares”, Lorelei Tolson, Trust & Estates, New York; July 2008 Vol. 137, Iss. 7; page 59
  • New Problems for the Unwary in Estate and Gift Tax Valuations: Penalties Under I.R.C. 6660”, Martha S. Scheer and Edward J. Gac, Accounting Horizons; Dec 1987; 1, 4, pg 69
  • Incomplete Gifts”, Michael Lynch, Journal of Accountancy, New York: Jan 1999. Vol 187 Iss. 1; pg 74

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