Donee Liability for Unpaid Gift Taxes – Who Pays When the Gift is in Trust?
10/27/2015Many sophisticated estate plans involve lifetime sales and/or gratuitous transfers to trusts of assets without a readily determinable value. If the IRS takes issue with the transferor’s valuation of the transferred property, it may assert that the transferor owes additional gift tax. However, if the transferor (the “donor”) is no longer in a position to pay the tax, or he simply refuses to the pay the tax, the IRS can turn to the recipient of the gift (the “donee”) under Section 6324 of the Internal Revenue Code (the “IRC”). IRC Section 6324(b) imposes personal liability on a donee for the unpaid gift tax (including interest and penalties) of the donor up to the amount of the gift she received. A donee is liable not just for unpaid tax in respect of her gift, but for unpaid tax on all gifts made by the donor in that same calendar year (again, capped at the total amount of the gift actually received). Furthermore, as a personal liability, the IRS can collect the tax against all of the donee’s assets, not just the gift received. In the case of gifts of property held in trust, it is not so clear on whom this donee personal liability should fall – the trust estate or one or more of the trust beneficiaries? Logic and practical considerations appear to tip the scales toward the trust estate, but there is conflicting law on the question.
Over 60 years ago, in Fidelity Trust Company v. Commissioner, 141 F.2d 54 (3d Cir. 1944), the U.S. Court of Appeals for the Third Circuit held with respect to gifts made in trust that the trust estate, rather than the trust beneficiaries, was the donee for purposes of the predecessor provision to IRC Section 6324(b). The court found that the trust estate was the donee/transferee in the common use of the term since it was the one to whom something was transferred. The court further acknowledged the difficulties in treating the beneficiaries as donees and imposing a personal liability on them since (a) the beneficiaries who would ultimately receive the income and corpus were not then known and (b) there is a valuation problem as to what any beneficiary might be considered to receive – a problem unanswered by the government. For example, assume Father transfers 100 shares of FamilyCo stock to Trust under the terms of which Trustee has complete discretion to make distributions of income or trust corpus to and among Father’s four daughters during their lifetimes and then among their children until the youngest reaches age 35. The IRS determines that Father undervalued the FamilyCo shares, assesses gift tax on the additional value, but is unable to collect the tax from Father. As the Third Circuit recognized, if donee liability falls at the beneficiary level rather than the trust level, as to any particular beneficiary, it cannot be known what she might receive from the trust and assigning a value to her interest, and thereby determining the ceiling of her personal liability, seems an impossible task.
However, ten days after Fidelity Trust, the U.S. Court of Appeals for the Seventh Circuit reached the opposite conclusion in Fletcher Trust Company v. Commissioner, 141 F.2d 36 (7th Cir. 1944), holding “that the beneficiaries of a gift in trust are the donees” for purposes of the predecessor provision to IRC Section 6324(b). Although the interests of the trust beneficiaries in Fletcher Trust were similar to those in the above example (i.e., future and/or discretionary), the court skirted the troubling questions about quantifying and valuing such interests. The government was not attempting to collect the unpaid gift tax directly from any particular beneficiary. Instead, relying on what is now IRC Section 6903(a), the government sought to collect the tax from the trustee in its capacity as a fiduciary of the beneficiaries. IRC Section 6903 provides, in part, that “any person [that] is acting for another person in a fiduciary capacity. . . shall assume the powers, rights, duties and privileges of such other person in respect of a tax imposed by [the Code]” and the court agreed that the provision operates to impose liability on the trustee in respect of the donee liability of the beneficiaries. The Third Circuit specifically rejected this circuitous collection route in Fidelity Trust.
Whether this was a proper application of IRC Section 6903 could merit its own separate discussion, but assuming for this purpose that it was, since IRC Section 6903 imposes only a liability derivative of the beneficiaries’ liability under IRC Section 6324(b) (i.e., not a personal liability of the trustee) and limits the source of tax collection “from the estate” of the person for whom the fiduciary is acting (the beneficiaries/donees), one might still think relevant the questions regarding the quantification and valuation of beneficial interests. However, at least in the case of collection solely from the trustee, those questions can be avoided if every potential beneficiary of the trust for all time is treated essentially as a single collective donee, the sum of whose beneficial interests equals 100% and whose “estates” in respect of the trust equals the trust estate. Though it did not do so explicitly, this is precisely the approach that the Seventh Circuit appeared to adopt. Whether right or wrong, this approach gets you to the same place vis-à-vis the trustee and trust estate as when the trust estate is treated as the donee for purposes of IRC Section 6324(b). That is, the trustee, whether acting for the trust estate or the collective beneficiary, must pay the unpaid gift tax (including interest and penalties) up to the amount of the gift transferred to the trust from the assets of the trust. However, it is vis-à-vis the beneficiaries where the shortcomings of the Seventh Circuit’s approach are highlighted. Under Fletcher Trust, the government is also able to collect directly from any beneficiary on her personal donee liability under IRC Section 6324(b), but in order to do so, the government would finally have to confront the issue of quantifying and valuing that beneficiary’s gift. When an approach makes it easy to collect a derivative collective liability without having to address the difficulties inherent in determining any particular component of the underlying substantive liability, it is perhaps an indication that it is not the best approach.
Moreover, the circuitous collection route adopted in Fletcher Trust potentially fails to operate if only certain trust beneficiaries, rather than all possible trust beneficiaries as a whole, are treated as the donees of a gift transfer made in trust. Witness the recent decision of United States v. Marshall, U.S. App. LEXIS 14584 (5th Cir. Aug. 20, 2015), in which the U.S. Court of Appeals for the Fifth Circuit held not just that beneficiaries, rather than the trust estate, are the IRC Section 6324(b) donees of gifts made in trust, but also that the trust’s income beneficiary was the only such donee. Grossly oversimplified, Marshall involved unpaid gift taxes resulting from a valuation adjustment in respect of shares in a family company that were held in part by a trust which had been settled several years prior to the gift by the donor’s ex-wife (Eleanor). Under the terms of the trust, Eleanor was entitled to distributions of trust income for a period of 10 years (and nothing else), after which trust corpus was distributed to her son and the trust terminated. At the time of the subject gift, there were four years remaining on the term of the trust, and by the time the IRS assessed the additional gift tax against the donor, the trust had a few months earlier distributed all assets to Eleanor’s son and terminated. The donor’s estate did not pay the gift tax and the government sued Eleanor (the income beneficiary) for the tax on the entire amount of the gift on the basis that she had donee liability under IRC Section 6324(b). Notwithstanding that her son had received the entirety of the trust corpus as remainder man, the Fifth Circuit agreed and held that, as the only beneficiary of the trust with a present interest at the time of the gift, Eleanor was the only donee of the gift under IRC Section 6324(b).
If, under Marshall, only beneficiaries with a present interest in a trust can be considered donees for purposes of IRC Section 6324(b), this could actually prove detrimental to the government. For instance, in the case of a fully discretionary trust such as the one created by Father in the earlier example, there is no beneficiary with a present interest and thus there would be no donee with respect to whom personal liability under IRC Section 6324(b) could ever arise. The IRS would not be able to assert donee liability against anyone. Even in a case more similar to Marshall where a single beneficiary has an income interest for life with the remainder to others, the IRS may face a shortfall between what it is permitted to collect from the donee(s) and the total amount of the gift. For example, assume donor X transfers valuable assets to a trust under the terms of which X’s elderly Aunt Tilly is entitled to trust income for her life, and on Tilly’s death, all trust assets are distributable to X’s children. X skips out on his gift tax bill and the IRS is unable to collect the tax from him. If, under Marshall, Aunt Tilly is the only donee in respect of the gift for purposes of IRC Section 6324(b) because she is the only beneficiary with a present interest, the amount that the IRS can collect directly from Aunt Tilly (or from the trustee derivative of her liability) is limited to the value of her gift. One could easily determine an actuarial value for Aunt Tilly’s life interest, but given her advanced age, that value and the amount that the IRS can collect under IRC Section 6324(b) will fall significantly short of the value of the transferred assets.
Because of the factual peculiarities in Marshall, the government did not face this collection shortfall. Well before suit was brought against the donees, the donor’s estate had entered into a stipulation with the IRS that attributed to Eleanor a gift valued at $36 million (nearly the full amount of the gift in trust and many times greater than any benefit Eleanor received), and the court held that Eleanor was bound by the value set out in such stipulation. The propriety of that particular holding is beyond the scope of this discussion, but in any event, it seems unlikely that the government will be able to consistently avail itself of similar agreements and thus could easily find itself facing the shortfall issue. Nonetheless, it appears that the IRS’s general position on the matter of donee liability for gifts made in trust aligns with the Fifth Circuit’s. The Internal Revenue Manual (Section 18.104.22.168, ¶8) provides that a gift to a trust is “a gift to the beneficiaries of the trust who held a present interest in the trust” and donee liability may be asserted against such donees. However, the manual also notes that “these cases are often fact dependent” and instructs agents to consult with IRS Counsel before asserting donee liability against the beneficiary of a trust, so perhaps it is hedging its bets.
In sum, we currently face unsettled law on the operation of IRC Section 6324(b) in the context of gifts made in trust. The Third Circuit’s interpretation in Fidelity Trust treating the trust estate as the donee seems imminently logical (a provision aimed at collecting the unpaid gift tax follows the money to the person that actually got it) and practical (the determination and valuation of any particular beneficiary’s interest is irrelevant). The Seventh Circuit’s apparent interpretation treating all possible beneficiaries as donees works well if the government collects only from the trustee on the collective derivative liability, but potentially faces valuation obstacles if the government needs to collect directly from the beneficiaries. The Fifth Circuit’s interpretation which appears to treat only those beneficiaries with a present interest as donees, does not raise tricky quantification/valuation issues in respect of future and/or discretionary beneficiaries (since they are not “donees”), but leaves the IRS facing a potential shortfall. With great interest, we will keep an eye on whether courts for any other circuits, or perhaps, in view of the apparent split in the circuits, the Supreme Court weighs in on the matter.
In the meantime, if you have any questions about personal donee liability for gift taxes under IRC Section 6324(b) whether in general or how it might potentially affect any trust arrangements in which you have an interest or are contemplating undertaking, please feel free to contact Fred Feingold.
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