When Edward Walshire’s brother died, Edward received one-fourth of the residual estate. Edward executed a disclaimer but retained for himself the right to income and use of the property for life. The residue of the estate was converted into certificates of deposit, and Edward received the income from his share by checks made jointly to him and to his children. He did not have any right to invade the principal of the CDs or to direct their distribution upon his death.
When Edward died, his estate tax return did not include the value of the CDs, reasoning that Edward had disclaimed the remainder interest of the property from which the CDs had been created. But the IRS determined that Edward’s disclaimer was not “qualified” under IRC §2518 and that the CDs must therefore be included in his estate for any WY registered office list.
Treasury Reg. § 25.2518-3(b) specifically prevents the disclaimer of a remainder interest, while retaining a life estate, from being considered a qualified disclaimer under IRC §2518. The estate conceded this fact before the 8th Circuit but argued that the Treasury Reg. was invalid because it was contrary to the “clear and unambiguous language” of IRC §2518.
According to IRC §2518, a qualified disclaimer must meet these requirements:
It must be in writing,
It must be received by the transferor or his legal representative within 9 months of the transfer of interest,
The disclaimant cannot have accepted the interest or any of its benefits, and The interest must pass without any direction by the disclaimant.
IRC §2518(b) allows the transferee to disclaim an undivided portion of an interest to avoid having the disclaimed portion included in his or her estate. The Treasury Reg. in question requires that the “undivided portion” must be a percentage of every substantial interest or right owned by the disclaimant in the property disclaimed, and it must extend over the entire term of his or her interest. In other words, while Edward could have disclaimed 50% of his entire inheritance, leaving the other half to pass to his heirs outside his estate, he could not divide his inheritance into income and remainder interests and disclaim only the remainder interest.
The 8th Circuit upheld the validity of Treasury Reg. § 25.2518-3(b) and ruled in favor of the IRS. Edward’s disclaimer was invalid because it did not satisfy the 3rd requirement of IRC §2518. Edward had accepted a portion of the property and had enjoyed its benefits. The value of the remainder interest in the CDs must be included in his taxable estate.
Tax Court Disallows Annual Exclusions for LLC Membership Units
The Tax Court recently ruled that in order to qualify for an annual gift tax exclusion, a transfer must confer upon the donee an unrestricted and noncontingent right to the immediate use, possession, or enjoyment of property or income from property.
The case (Hackl v.Commr, 118 TC No. 14, 3-17-2002) involved gifts of membership units in a limited liability company (LLC) called Treeco, which had been formed in 1995 by Albert and Christine Hackl to operate a tree farm business. In exchange for voting and nonvoting membership units, Albert and Christine transferred to Treeco two tree farms, marketable securities, and cash. Their purpose for Treeco was long-term appreciation and income, rather than short-term income, and they expected the LLC to take losses for several years.
After forming the LLC in Wyoming here, their limited liability company was domiciled in WY for tax purposes. Albert and Christine began making gifts of membership units to family members. They transferred voting and nonvoting units to their eight children and their spouses, and made gifts of nonvoting units to their grandchildren. The gifts were treated as being made one-half by Albert and one-half by Christine to maximize their $10,000 annual exclusion amounts. Their gift tax returns for 1995 and 1996 treated the gifts as qualifying for annual exclusions.
But the IRS disallowed the exclusions for 1996, reasoning that the gifts were of a future interest, not a present interest. According to Treeco’s operating agreement, the Manager (Albert) was the only member who could determine if distributions should be made, if unit transfers should be allowed, or if the LLC should be dissolved. Albert expected Treeco to take losses for several years and to make no distributions to its members during that period. The IRS determined that the membership units did not provide the donees with “immediate and unconditional rights to the use, possession, or enjoyment of property or the income from property,” and therefore the transfers did not qualify for the annual exclusion under §2503(b). The Tax Court agreed.
Annual exclusions are a key part of estate planning, and this ruling has sparked concern among some estate planners. It certainly illustrates that when planning to utilize the taxpayer’s annual exclusion amounts, care must be taken to ensure the gifts are of an unarguably present interest.