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IRS Suffers Estate Tax Loss: An In-Depth Look at Estate of Kite v. Commissioner (Parker's Federal Tax Bulletin: February 18, 2013)

The transfer of family partnership interests to the decedent's children in exchange for annuity agreements was not a disguised gift subject to gift tax; but portions of the annuities traceable to the ownership interest of QTIP trusts in the family partnership, less the value of the decedent's qualifying income interests in those trusts, were subject to gift tax. (Estate of Kite v. Commissioner, T.C., No. 6772-08, T.C. Memo. 2013-43, 2/7/13).

Mrs. Kite was the current income beneficiary of four trusts two qualified terminable interest property (QTIP) trusts, one marital deduction trust, and one revocable trust. In 2001, the QTIP trusts and the marital deduction trust were liquidated, and the trusts' assets, which consisted entirely of family partnership interests in the Kite Family Investment Co. (KIC), were transferred to Mrs. Kite's lifetime revocable trust. The family partnership interests held by the lifetime revocable trust were then transferred to Mrs. Kite's children in exchange for 10-year deferred private annuity agreements. In addition to consulting her family and business advisers, Mrs. Kite, who was 74 years old at the time, contacted her physician. Her physician sent Mrs. Kite a letter attesting to her longevity and health. Each of the Kite children promised to pay $1,900,679 to Mrs. Kite's lifetime revocable trust on March 30 of every year beginning in 2011 and ending on Mrs. Kite's death. The Kite children did not make any annuity payments to Mrs. Kite before she died on April 28, 2004.

The IRS assessed a deficiency because, it argued, the transfer of the KIC partnership interests to Mrs. Kite's children in exchange for the annuity agreements was not made for adequate and full consideration. According to the IRS, the transfer was a disguised gift subject to gift tax. The IRS contended that the annuity agreements did not constitute adequate consideration because they were structured to ensure that no annuity payment would be made and there was no real expectation of payment. The IRS did not challenge the physician's letter or present evidence contradicting the physician. Instead, it relied on Mrs. Kite's 24-hour medical care at home, which began in 2001, and her increased medical costs from 2001 through 2003 to conclude that her death within the next 10 years was foreseeable.

Alternatively, the IRS argued that the annuity transaction, and the events leading up to it, should be disregarded and, as a result, Mrs. Kite's $10.6 million of KIC interests was includible in her gross estate under Code Sec. 2033. According to the IRS, the annuity transaction constituted a disposition of the qualifying income interests for life, as described in Code Sec. 2056(b)(7), which Mrs. Kite held in the corpuses of the QTIP trusts such that the dispositions constituted taxable gifts under Code Sec. 2519. The IRS also argued that Mrs. Kite made a taxable transfer under Code Sec. 2514 when she effectively released her general power of appointment over the corpus of the marital deduction trust.

The estate relied on the decision in Est. of McLendon v. Comm'r, 135 F.3d 1017 (5th Cir. 1998), in arguing that the annuity transaction was for adequate and full consideration because the parties used IRS actuarial tables to properly value the annuities. The estate further contended that the parties intended to comply with the terms of the annuity agreements, which were legally enforceable under state law, and that this intent was supported by the Kite children's ability to make payments under the annuity agreements and Mrs. Kite's profit motive.

The Tax Court held that, based on Mrs. Kite's position of independent wealth and sophisticated business acumen, the annuity transaction was a bona fide sale for adequate and full consideration.

Although the QTIP trust agreements authorized the Kite children, as trustees, to terminate the QTIP trusts in their discretion, the court noted that the estate had presented no explanation of why the QTIP trusts were terminated immediately before the transfer of the QTIP trust assets. According to the court, by creating an intermediary step in the annuity transaction, i.e., terminating the QTIP trusts before selling the QTIP trust assets to the Kite children, Mrs. Kite's transfer of her ownership interests in KIC would circumvent the QTIP regime and avoid any transfer tax imposed by Code Sec. 2519. Accordingly, the Tax Court found that the termination of the QTIP trusts and the following immediate transfer of the QTIP trust assets to the Kite children was a single transaction for purposes of Code Sec. 2519. Thus, the Tax Court concluded that the portions of the annuity value originally traceable to the ownership interest of QTIP trusts in KIC, less the value of Mrs. Kite's qualifying income interests in those trusts, were subject to federal gift tax as of the simultaneous termination of the marital trusts and the transfer of the marital trust assets in 2001.

(Staff Editors at Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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