When bad facts make bad law, there’s a tendency to dismiss the result. The U.S. Tax Court case of Estate of Moore v. Commissioner1 raised a correct conclusion about valuation adjustment clauses but used a flawed analysis. Although Moore is a memorandum decision, meaning it’s not citable as precedent, it merits study especially because the U.S. Court of Appeals for the Ninth Circuit Court affirmed the result without potentially undermining valuation adjustment clauses.2
Valuation Adjustment Clause
Howard Moore, who was age 89 and had a terminal illness, sought to minimize estate taxes on his extensive real estate holdings. Howard owned a farm that spanned approximately 845 acres in Arizona. His lawyer created a complex estate plan with several trusts: (1) the Moore Living Trust (MLT), (2) an irrevocable trust, and (3) a charitable lead annuity trust (CLAT). The lawyer also created a family limited partnership (FLP).After Howard’s death, proceeds from the lifetime sale of his farm were then to be transferred to the irrevocable trust, then through to the MLT and ultimately to the CLAT. The MLT was to distribute to the CLAT enough to result in the least possible federal estate tax being payable by the estate. This valuation adjustment clause is often employed in charitable planning as well as marital deduction planning.
The Internal Revenue Service issued a notice of deficiency to the estate for $6.4 million, asserting, among other arguments, that the value of the farm should be included in the gross estate despite having been sold during the decedent’s lifetime to the FLP. The estate appealed to the Tax Court.
Charitable Bequest Uncertain
The court included in the gross estate the undiscounted value of Howard’s farm invoking Internal Revenue Code Section 2036(a) because there hadn’t been a showing of a bona fide sale for adequate and full consideration in money or money’s worth. Additionally, the decedent had continued to live on the farm after its sale to the FLP.
Nor did the court see a legitimate, non-tax reason for the formation of the FLP. Because the FLP sold the farm within five days of receipt, the justification of an FLP for management of it rang hollow. The children agreed to become partners in the FLP at the decedent’s request. None of the children sought independent legal counsel to do an arm’s-length negotiation of the terms of their ownership interests in the FLP. Nor could a need for creditor protection be convincing because there were none, current or imminent. Surprisingly, after receiving the real estate holdings, including the farm during Howard’s lifetime, the FLP sold it to outsiders. Because the decedent continued to live on the farm, the undiscounted value of the real estate was included in the gross estate.
The court didn’t permit a charitable deduction to mitigate the size of the taxable estate. The valuation adjustment clause was part of the irrevocable trust, and the value of the farm wasn’t deemed to be an asset of the irrevocable trust. Instead of denying the deduction solely based on the faulty drafting, the Tax Court found that the formula clause created a contingency (the auditing of the decedent’s estate tax return resulting in the additional inclusion of property). Thus, it was uncertain whether there would be a charitable bequest. The amount of the charitable deduction wasn’t ascertainable at death within the meaning of Section 2055(d).
Denial of Deduction Upheld
The Ninth Circuit upheld the denial of the estate’s charitable deduction from the transfer of the sales proceeds of the farm to the decedent’s CLAT.3 The court reached its result without analyzing the legality of the zero tax formula clause. It simply interpreted the language of the irrevocable trust as not requiring transfer from it through the MLT to the CLAT. Because the funds going to charity weren’t included in the gross estate, there could be no charitable deduction.
Planning Pointers
While it can be difficult for planners to sit by and do nothing for a terminally ill client, sometimes doing less is more impactful and less expensive. The decedent incurred nearly $800,000 in attorney’s fees for documents and estate administration for a failed strategy that had little likelihood of success. Had nothing been done, the heirs at a minimum would have been spared 14 years of litigation expenses.
Moore reminds the drafter of the necessity of “following the money” trail to be sure the source of a testamentary charitable gift was in fact included in the gross estate. Here, a second set of eyes reviewing the documents in their totality might and probably would have caught the likely denial of deductibility from an “irrevocable trust.”
Additionally, not only must the asset going to charity be in the gross estate but also the amount must be ascertainable at death. Treasury Regulations Section 25.2522(c)-3(b)(1) provides that no charitable deduction is allowed if, as of the date of a gift, the “transfer for charitable purposes is dependent upon the performance of some act or of the happening of a precedent event in order that [the transfer] might become effective.”
Moore continues a decades-long trend of increasing scrutiny and application of Section 2036(a) to deathbed transfers.4
Endnotes
1. Estate of Moore v. Commissioner, T.C. Memo. 2020-40 (April 7, 2020).
2. Moore et al. v. Comm’r, 128 A.F.T.R.2d, 2021-6604 (9th Cir.) (Nov. 8, 2021).
3. Ibid.
4. For a thorough analysis of the seminal cases interpreting Internal Revenue Code Section 2036, see Beckett Cantley and Geoffrey Dietrich, “How Soon is Now: Estate of Moore& the Unraveling of Deathbed Estate Planning,” 34 Quinnipiac Prob. L.J. 141 (2021).