Estate Not Allowed a Deduction for Unpaid Gift Tax Related to a Net Gift

When a taxpayer has made a “net gift” within three years of the taxpayer’s death, how is that gift handled for purposes of the “gross up” rule for such gifts found in IRC §2035(a) and (b)?  In the case of Estate of Sommers v. Commissioner, 149 TC No. 8, the taxpayer argued that the estate should be allowed a deduction on the Form 706 for the gift tax that was paid by the donors.

There is a transfer tax advantage to making fully taxable gifts prior to the date a taxpayer dies and paying the gift tax.  Although the estate and gift taxes are now “unified” with the same rates being applied, the gift tax is not imposed on the amount that is actually used to pay the gift tax—rather that tax is removed from the pool of assets that will eventually be subject to the tax. 

If the asset is held until the taxpayer dies, the funds to pay the estate tax will come from the pool of assets that are also subject to the estate tax—funds that would not be there if the item had been gifted before death.

To keep taxpayers from taking advantage of this by making substantial gifts just before death, Congress added IRC §2035 which requires including in a taxpayer’s estate both amounts gifted within three years of the date of death and the gift tax on that item, subjecting the funds used to pay the gift tax to estate taxes.

IRC §2035(a)(1) provides:

(a) Inclusion of certain property in gross estate


(1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent’s death…

the value of the gross estate shall include the value of any property (or interest therein) which would have been so included.

While §2035(b) provides:

(b) Inclusion of gift tax on gifts made during 3 years before decedent’s death

The amount of the gross estate (determined without regard to this subsection) shall be increased by the amount of any tax paid under chapter 12 by the decedent or his estate on any gift made by the decedent or his spouse during the 3-year period ending on the date of the decedent’s death.

In the case before the Court the taxpayer had made gifts to his nieces just prior to his death.  While the taxpayer had attempted to structure gifts that would avoid gift taxes, it was determined when the valuation of the interests was obtained that this would not be possible.  Thus, as a condition of accepting the gift, the nieces agreed to pay the gift tax due on the gift. 

Such a structure is referred to as a “net gift” which the IRS recognized in Rev. Rul. 75-72.  In the case of a net gift, the amount of the gift is reduced by the gift tax which the donee pays.  In this case, the gift in question was made in the year in which the decedent died.  The nieces paid the gift tax due on the gift.

When it came time to prepare the Form 706, the estate did include the net gift value reported on the Form 709 on the Form 706 for the estate, but argued that the estate should be able to claim as a deduction the gift tax that had yet to be paid at the date of death on that gift.  The estate argued that such taxes were clearly deductible by the estate under Reg. §20.2053-6(d).  That regulation provides:

(d)Gift taxes.

Unpaid gift taxes on gifts made by a decedent before his death are deductible. If a gift is considered as made one-half by the decedent and one-half by his spouse under section 2513, the entire amount of the gift tax, unpaid at the decedent's death, attributable to a gift in fact made by the decedent is deductible. No portion of the tax attributable to a gift in fact made by the decedent's spouse is deductible except to the extent that the obligation is enforced against the decedent's estate and his estate has no effective right of contribution against his spouse. (See section 2012 and § 20.2012-1 with respect to credit for gift taxes paid upon gifts of property included in a decedent's gross estate.)

The Tax Court did not accept this view.  The Court noted that:

The key question when considering the deductibility under section 2053(a)(3) of gift tax owed on a net gift, as opposed to inclusion of that amount in a decedent's gross estate under section 2035(b), is not whether the decedent (or his estate) served as the ultimate source of the funds used to pay the liability but when the decedent parted with that value.

In the case of a net gift, the Court reasoned that the assets to be ultimately used to pay the gift tax were transferred to the donees prior to the date of death. Thus, for the estate, there did not exist an unpaid gift tax as of the date of death for which a deduction under Reg. §20.2053-6(d).

The taxpayer argued that this should not be relevant, since the estate was ultimately liable to assure that the gift tax was paid.  But, the Court noted, even if the donees had failed to make the payment and the estate had been required to pay the tax (which did not take place), the estate would have had a clear claim against the donees to be reimbursed for that payment.

The estate attempted to take comments made by the Tax Court in the case of the Estate of Morgens (133 T.C. 402) to support its position.  The Tax Court noted that the comments were not directly related to the actual issue in Morgens and, in any event, the taxpayer was taking the comments out of context.  As the Court explained:

Read in context, our passing acknowledgment in Estate of Morgens that net gifts remove funds from the transfer tax base simply describes the reality that the excess of the value of the property transferred in a net gift over the taxable gift reduces the value of the donor's gross estate but is also excluded from the taxable portion of the gift. Consequently, that excess value (the gift tax on the net gift) would escape transfer tax altogether were it not subject to the section 2035(b) gross-up. Because a net gift depletes the donor's estate beyond the value taken into account for gift tax purposes, the gross-up is necessary. Our acknowledgment that a net gift made within three years of the donor's death effects a removal of funds from the transfer tax base that must be redressed by the gross-up cannot be read as acquiescence in the permanent exemption from transfer tax that would result if the gross-up were offset by a deduction of the same amount under section 2053(a)(3).