donative promise can lock in 2012 gift tax exemption · passed the two acts-namely, the economic...
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Checkpoint Contents
Estate Planning Library
Estate Planning Journals
Estate Planning Journal (WG&L)
Estate Planning Journal
2012
Volume 39, Number 08, August 2012
Articles
Donative Promise Can Lock in 2012 Gift Tax Exemption, Estate Planning Journal, Aug 2012
DONATIVE PROMISE
Donative Promise Can Lock in 2012 Gift Tax Exemption
The gift of a promise to make a future payment can be sheltered by the currently
generous gift tax exemption while letting the donor retain present control of his or her
wealth.
Author: AUSTIN W. BRAMWELL, ATTORNEY
AUSTIN W. BRAMWELL is an associate in the trusts and estates department of Milbank,
Tweed, Hadley & McCloy LLP. The views expressed herein are his own.
[pg. 3]
Not all taxpayers feel that they have the wherewithal to take advantage of the increased gift tax exemption
available this year. An individual worth exactly $5.12 million who has made no prior taxable gifts, for
example, would need to make a gift of all his or her assets in order to use up the gift tax exemption in full.
Although the $2,111,000 in potential estate tax savings from using up the gift tax exemption this year
represents a full 41.2% of his or her wealth, he or she may still be reluctant to make substantial taxable gifts.
It is possible, to be sure, to make taxable gifts this year without necessarily losing access to one's wealth.
For example, an individual could make a gift to:
(1) A qualified personal residence trust (QPRT) in which he or she retains the right to income for a
period of years.
(2) A "spousal access trust" for the benefit of the donor's spouse and descendants.
(3) A discretionary trust for the donor's own benefit that is created in a jurisdiction where the trust
assets will generally be protected against the claims of the donor's creditors.
None of these strategies, however, provides total comfort. The donor of a QPRT loses the right to live in his
or her residence if he or she survives the fixed term. Similarly, the donor of a spousal access trust risks
losing access to the trust property if he or she outlives the beneficiary spouse. 1 A self-settled trust,
meanwhile, does not escape gross estate inclusion if the IRS can establish that there was an implied
understanding that the trust property would be made available to the donor as a "rainy day" fund. 2 Many
taxpayers, therefore, even if advised of the full panoply of conventional estate tax planning techniques, will
ultimately choose not to take advantage of the full $5.12 million gift tax exemption available this year.
This article proposes an alternative technique that almost all such taxpayers should consider. The
technique is simple: Rather than give away cash or other property in 2012, a taxpayer can promise to
transfer cash or other property to the donees in the future. To the extent that the promise is not made for full
and adequate consideration in money or money's worth, it will be treated as a taxable gift, provided that it is
enforceable under local law. Consequently, a gift in the form of a promise to pay money in the future, if
enforceable under local law, can use up gift tax exemption in 2012 yet permit the donor to retain complete
ownership and control of his or her assets. It also
[pg. 4]
has nontax benefits that some donors may find compelling.
Gift and estate tax consequences of a donative promise
To understand the consequences of making a donative promise to pay money or other property in the
future, 3 it may help to begin by considering what the consequences would be if the gift and estate tax
exemption amounts were not scheduled to decline in 2013. Suppose, for example, that Congress had never
passed the two acts-namely, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)
and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010
(TRUIRJCA)-under which the gift and estate tax exemptions will revert to $1 million in 2013. Suppose,
further, that an individual living in this non-EGTRRA, non-TRUIRJCA world has $5 million of wealth, of
which he or she gives $1 million to a trust for descendants that does not qualify for the gift tax annual
exclusion.
If the individual dies shortly thereafter with a $4 million taxable estate, the estate tax due-again, in a world
without EGTRRA or TRUIRJCA-would be determined, first, by calculating a tentative tax on the sum of the
$4 million taxable estate and the $1 million lifetime gift. The $1 million lifetime gift would be included in the
calculation of estate tax as an "adjusted taxable gift." 4 The estate would then be entitled under Section
2010 to a credit equal to a tentative tax on the $1 million. Thus, the first $1 million of the taxpayer's original
$5 million of wealth (i.e., the $1 million lifetime gift) would be sheltered from both gift and estate tax.
Now suppose that, instead of transferring cash, an individual living in a non-EGTRRA, non-TRUIRJCA
world promises to pay an amount in the future whose then present value is $1 million. In this case, once the
promise becomes binding under local law, the individual would again be treated as making a $1 million
taxable gift. 5 If he or she dies while the obligation is outstanding, his or her estate would be liable for the
debt. Nevertheless, the obligation could not be deducted from the value of the taxable estate. On the
contrary, Section 2053(c)(1)(A) generally disallows deductions for claims, if founded on an agreement or
promise, that were not contracted for full and adequate consideration in money or money's worth. As the
taxpayer's promise in this case was not contracted for a valuable consideration, it could not be deducted
against the taxable estate.
On the other hand, the $1 million gift would not be included in the calculation of estate tax as an adjusted
taxable gift. To be sure, the $1 million gift would technically meet the requirements of an "adjusted taxable
gift" under Section 2001(b), as the gift would have been made after 1976 and would not be included in the
gross estate. A literal application of the definition of "adjusted taxable gift," however, would lead to double
taxation: if the $1 million gift were included in the estate tax calculation yet the obligation did not reduce the
taxable estate, then estate tax would be imposed on $6 million (i.e., the $5 million taxable estate plus the $1
million lifetime gift), even though the decedent would have transferred only $5 million of wealth. To avoid
this result, the IRS held in Rev. Rul. 84-25 that a donative promise to make a payment in the future,
although not deductible against the taxable estate, is also not an adjusted taxable gift. 6 In this example,
therefore, estate tax would be calculated on the $5 million amount, just as if the taxpayer had made a gift of
$1 million cash.
Rev. Rul. 84-25 7 inadvertently creates a planning opportunity in an era of declining exemption amounts. Let
us now consider an individual living in the actual world of EGTRRA and TRUIRJCA. Suppose that he or she
has exactly $5.12 million of wealth and has made no prior taxable gifts. Instead of making a gift this year of
property or cash, the individual promises to transfer in the future to his or her children an amount in the
future having a present value of
[pg. 5]
$5.12 million. If the promise is binding under local law, the individual is treated under Rev. Rul. 84-25 as
having made a taxable gift of $5.12 million. The gift successfully uses up his or her entire lifetime gift tax
exemption.
Now suppose that the individual dies in 2013 when the estate tax exemption amount is only $1 million.
Section 2053(c)(1)(A) will deny a deduction for the debt to the children. Assuming, for simplicity, no other
deductions, the individual's taxable estate will, therefore, be equal to the full $5.12 million of assets. Under
Rev. Rul. 84-25, the $5.12 million taxable gift made in 2012 will not be included in the calculation of estate
tax as an adjusted taxable gift. If the taxpayer had instead given away all his or her wealth and died with a
taxable estate of $0, the result would be the same: in both cases, he or she would be treated as having
made a $5.12 million taxable gift, and the estate tax at death would be calculated on the amount of $5.12
million. 8 A donative promise to pay money in the future uses up lifetime gift tax exemption just as effectively
as a gift of cash.
Claw-back wrinkle. Whether a 2012 gift of a donative promise will ultimately save estate tax depends on
whether the IRS can successfully "claw back" tax on the difference between the $5.12 million exemption
available in 2012 and the $1 million exemption available in 2013. This question has been discussed at
length elsewhere. 9 In brief, the estate tax is determined, first, by calculating a tentative tax on the sum of the
taxable estate and the decedent's adjusted taxable gifts. In 2013, the tentative tax on $5.12 million will be
$2,456,800. This tentative tax will then be reduced under Section 2001(b)(2) by "the aggregate amount of
[gift] tax which would have been payable ... with respect to gifts made by the decedent after December 31,
1976," if the gift and estate tax rate table of Section 2001(c) in effect at the decedent's death "had been
applicable at the time of such gifts."
If the hypothetical gift tax "which would have been payable" is calculated after applying the same Section
2505 credit that was available in 2012-i.e., a credit equal to the gift tax on $5.12 million-then the hypothetical
gift tax on the $5.12 million gift would be $0. Consequently, there would be no reduction of tax under
Section 2001(b)(2). The IRS, in short, would recapture tax on the $5.12 million gift made in 2012.
On the other hand, if the gift tax "which would have been payable" is calculated using the same Section
2505 credit that is available in 2013 (i.e., a credit equal to the gift tax on only $1 million), the hypothetical gift
tax "which would have been payable" on the $5.12 million gift made in 2012 would be $2,111,000.
Consequently, the tentative estate tax of $2,456,800 would be reduced under Section 2001(b)(2) to
$345,800, which would be the full amount of the unified credit under Section 2010. No estate tax would be
due. The IRS would not, in short, recapture tax on the $5.12 million gift made in 2012.
Whether the IRS can recapture tax on gifts made under the increased gift tax exemption amounts under
TRUIRJCA depends on the proper interpretation of Section 2001(b)(2). On one reading of the Code (as it
would exist in 2013), the IRS may indeed recapture tax, as, while Section 2001(b)(2) says to calculate the
hypothetical gift tax by assuming a different rate schedule than the one in effect at the time of the gift, it says
nothing about the amount of unified credit to use. By negative implication, therefore, the unified credit in
effect at the time of the gift must be used. That reading, on the other hand, is arguably inconsistent with the
"sunset" provisions of EGTRRA and TRUIRJCA, 10 under which estate tax after 2012 must be calculated
[pg. 6]
as if those acts had never been enacted. The sunset provisions suggest that gift tax "which would have
been payable" in 2012 should be calculated assuming a $1 million lifetime gift tax exemption. 11
In any event, the potential for clawback exists regardless of the form of gifts made in 2012. Whether a
taxpayer makes a "conventional" gift of cash or instead makes a donative promise to pay money in the
future, the result should be same. To be sure, a gift of a deferred obligation may seem more abusive. If the
IRS can recapture tax on a gift of cash or property, the estate tax in some situations would be greater than
the entire value of the gross estate. For example, suppose a taxpayer gives away $5.12 million in 2012 and
dies in 2013 with a gross estate of $0. If clawback applies, the estate tax would be $2,111,000, yet the
estate would have no assets with which to pay the tax. 12 The possibility that the tax could exceed the gross
estate suggests that Congress never intended for clawback of tax to occur.
On the other hand, a taxpayer who makes a donative promise in 2012 to pay money in the future can, if the
IRS cannot recapture the tax, artificially reduce his or her estate tax burden to $0. Both seemingly absurd
results need to be considered in determining whether the IRS has the power to recapture tax on pre-2013
gifts. 13
Must a donative promise be "bona fide"?
To be respected for gift and estate tax purposes, transactions in many cases must be "bona fide" in the
sense that the parties intend to carry out the transactions in accordance with their terms. Examples of such
transactions include the following:
• Under Reg. 25.2512-8, an exchange of property is not subject to gift tax if it was bona fide, at arm's
length, and in the ordinary course of business.
• Under Sections 2036(a) and 2038(a), property transferred during lifetime that would otherwise be
included in a decedent's gross estate will not be so included if the transfer was made in a bona fide sale
for full and adequate consideration in money or money's worth. 14
• Under Section 2053(c)(1)(A), funeral expenses, expenses of estate administration, and claims against
an estate, when founded on a promise or agreement, may not be deducted from the taxable estate
unless contracted bona fide and for full and adequate consideration in money or money's worth. 15
• Under Reg. 20.2053-1(b)(2)(1), a claim or estate administration expense cannot be deducted against
the taxable estate unless it is bona fide and not donative or "a mere cloak for a gift or bequest."
• Under Rev. 20.2056(c)-2(d)(2), if a property interest is assigned to a surviving spouse as a result of a
will controversy, the interest is considered to have passed to the surviving spouse for marital deduction
purposes only if in "bona fide recognition of enforceable rights of the surviving spouse."
Sale or exchange. Another transaction that may be required to be bona fide, at least for gift tax purposes, 16 is a sale or exchange for a valuable consideration. Section 2512(b) provides that a transfer of property for
less than full and adequate consideration in money or money's worth is a taxable gift to the extent that the
value of the property transferred exceeds the value of the consideration received. 17 There is no
requirement in the Code or Regulations that the consideration be bona fide in order to reduce the taxable
gift. 18
Despite the absence of such a requirement, the IRS argued in Haygood 19 that the value of
[pg. 7]
promissory notes received by the donor in exchange for property should be ignored in determining the
taxable gift, as the donor had intended all along to forgive the notes. The Tax Court rejected the IRS's
position and held, on the contrary, that the notes were valuable consideration even though the donor had no
intent to collect. 20 The IRS, however, will not follow the decision in Haygood. Under Rev. Rul. 77-299, 21 a
note given in return for property must, in the view of the IRS, be bona fide as well as enforceable under local
law in order to be valuable consideration.
Gratuitous transfer counts. The IRS does not, however, require all transactions to be bona fide in order to
be respected for gift tax purposes. For example, in contrast to a note given as consideration, the IRS does
not require a note given gratuitously to be bona fide in order to be a taxable gift. Rev. Rul. 84-25 holds, on
the contrary, that the "gratuitous transfer of a legally binding promissory note is a completed gift." The
Ruling says nothing about whether the promisees intended to enforce the note or whether the taxpayer
intended to satisfy it. Whether a promise to pay money in the future is a taxable gift depends solely the
objective facts of enforceability.
Rev. Rul. 84-25 is but one application of the general principle that donative intent is not a requirement of a
taxable gift. As the U.S. Supreme Court put it in Wemyss: 22
Had Congress taxed "gifts" simpliciter, it would be appropriate to assume that the term
was used in its colloquial sense, and a search for "donative intent" would be indicated.
But Congress intended to use the term "gifts" in its broadest and most comprehensive
sense.... Congress chose not to require an ascertainment of what too often is an elusive
state of mind. For purposes of the gift tax it not only dispensed with the test of "donative
intent." It formulated a much more workable external test, that where "property is
transferred for less than an adequate and full consideration in money or money's worth,"
the excess in such money value "shall, for the purpose of the tax imposed by this title, be
deemed a gift...."
Reg. 25.2511-1(g)(1) reiterates that the "application of the [gift] tax is based on the objective facts of the
transfer and the circumstances in which it is made, rather than the subjective motives of the donor." In other
words, a taxpayer can make a transfer and have it treated as a taxable gift even if he or she has no actual
donative intention.
The prohibition on considering subjective intentions normally works against taxpayers. It is no defense
against gift tax liability, for example, that a transfer was not a gift under state law. 23 In 2012, by contrast, the
prohibition works in favor of taxpayers who wish to use up their lifetime gift tax exemption. In particular, a
subjective intent not to honor a promise to pay cash or other property in the future is irrelevant to whether
the promise is a taxable gift. On the contrary, under Rev. Rul. 84-25, the promise is a taxable gift so long as
it is enforceable under local law.
Any doubt as to whether a donative promise is a taxable gift can be resolved by adequately disclosing it as
such on a gift tax return. Once the gift is adequately disclosed and the period for assessment of gift tax
lapses, 24 any argument by the IRS that a donative promise is not a gift would be precluded. Further, under
Section 2001(f), the value of a gift as finally determined for gift tax purposes is the value that must be used
in order to calculate estate tax at death, including, presumably, the reduction of estate tax under Section
2001(b)(2) for gift tax that "would have been payable" during lifetime. 25 Even if the gift is ultimately
determined to have been incomplete, the gift tax assessment period will begin to run so long as the gift is
adequately disclosed and reported as a completed gift. 26 Thus, it seems that, if a donative promise is
reported as a taxable gift and the gift tax assessment period lapses, the IRS must treat the promise as a
taxable gift when calculating estate tax at death.
In other words, a taxpayer can, it seems, report a promise to transfer cash or other property in the future as
a taxable gift and, if the gift tax assessment period lapses, have the promise treated as a lifetime taxable gift
for estate tax
[pg. 8]
calculation purposes. Any taxpayer who makes a donative promise in order to use up lifetime gift tax
exemption in 2012 should be advised to report and adequately disclose the promise as a taxable gift. While
the IRS could, during the gift tax assessment period, challenge the taxpayer's position that the promise is a
taxable gift, 27 it may as a practical matter be unlikely to do so. In any case, the IRS will be precluded from
challenging the bona fides of the gift after the gift tax assessment period has lapsed.
Valuing the promissory note
Another question to be considered in making a donative promise to pay money in the future is the value of
the promise for gift tax purposes. Suppose, for example, that a taxpayer who is worth exactly $5 million
makes an unsecured promise to transfer $5 million to his or her children in five years. The note does not
bear any interest. The taxpayer wishes to report the promise as a gift and to use up as much of his or her
lifetime gift tax exemption as possible.
Willing buyer/seller standard. In general, the value of property for gift tax purposes is the "price at which
such property would change hands between a willing buyer and a willing seller, neither being under any
compulsion to buy or sell, and both having reasonable knowledge of relevant facts." 28 Reg. 25.2512-4 adds
that a promissory note may be valued at a discount based on various factors, including "the interest rate, or
date of maturity, or other cause" or because "the note is uncollectible in part (by reason of the insolvency of
the party or parties liable, or for other cause)" or because "the property, if any, pledged or mortgaged as
security is insufficient to satisfy it."
In light of these factors, the value of the taxpayer's $5 million note may, under a strict application of the
"willing-buyer-willing-seller" test, be considerably less than face. First, as no interest accrues on the note, a
present value discount might apply to the $5 million face value. Second, as the taxpayer has few assets with
which the repay the note, a discount might apply for lack of collectability. Finally, an additional discount
might apply because the note is not secured by any property. For these reasons, it appears at first that the
value of the note for gift tax purposes is less than $5 million.
Presumption of face amount. The "willing-buyer-willing-seller" test, however, is not the only provision that
governs the valuation of notes for gift tax purposes. Reg. 25.2512-4 states, for example, that the value of a
note "is presumed to be the amount of unpaid principal, plus accrued interest to the date of the gift, unless
the donor establishes a lower value." 29 Arguably, under this regulation, the IRS is not even permitted to
decrease the reported value of a note, as only the donor may "establish[] a lower value." In any case, as a
lower value must be affirmatively demonstrated, the taxpayer has the option, it seems, to report the face
value of any promissory note as its gift tax value. 30
Further, once the assessment period has lapsed, the IRS is precluded at death from revaluing the note for
purposes of calculating estate tax. 31 Thus, a taxpayer can generally report a gift of a donative promise to
pay money or other property in the future as being equal to the face amount of the obligation.
Planning consideration. That said, when valuing a term note given as a gift, it may be prudent to apply at
least a present value discount. Section 7872(d)(2), which was
[pg. 9]
enacted after Reg. 25.2512-4 was published, provides that, for gift tax purposes, a "below-market" term
loan is treated (in accordance with Section 7872(b)(1)) as if the lender transferred to the borrower the
excess of the amount loaned over the present value of all payments required to be made under the terms of
the loan. 32 For example, if a taxpayer loans $5 million to his or her children for five years and the note
received in exchange does not bear interest, the taxpayer is treated under Section 7872 as making a
taxable gift equal to $5 million less the present value of the payments due under the note. 33
Section 7872 may not, strictly speaking, apply where a taxpayer makes a donative promise to pay money in
the future. In that case, there may not even be a "loan" to which Section 7872 could apply, as the "lenders"
(i.e., the donees) will not have actually transferred money to the "borrower" (i.e., the donor). 34 Nonetheless,
the IRS has consistently taken the position that the present value method should be used to value term
notes. 35 For example, if a taxpayer makes a promise to pay $5 million to his or her children in five years, it
seems that, in the IRS's view, the value of the gift should be determined by taking the present value of the
obligation using the Section 7872 discount rate. Cautious taxpayers who use up gift tax exemption by
making a donative promise, therefore, should value the gift by applying at least a present value discount.
Making the note enforceable
As Rev. Rul. 84-25 holds, a promise to make a payment in the future is a taxable gift at the time that it
becomes enforceable. On the other hand, if the promise is unenforceable, no taxable gift occurs. 36 Whether
a promise is enforceable is a question of state law. 37 If a taxpayer wishes to use up his or her gift tax
exemption by making a promise to pay money in the future, therefore, it is crucial that the promise be
structured in such a way that it is binding on the donor.
As a general rule, a promissory note is enforceable to the same extent that a contract is enforceable. 38 In
order to make a note enforceable, therefore, it should be delivered to the donee pursuant to a valid and
enforceable contract. 39 In particular, the note must be delivered in exchange for consideration. Legally
sufficient consideration can take a variety of forms. For example, performance of an act 40 or a promise to
perform a future act 41 can both be sufficient consideration. Another example of valid consideration is an act
of forbearance. Thus, to take a classic example, refraining from smoking has been held to be sufficient
consideration. 42 Consideration can also take the form of a transfer of property, even though both parties
know that the property is being overvalued by the purchaser 43 and even if the value of the consideration is
grossly inadequate. 44
For many would-be donors, the requirement that a promissory note be supported by consideration is a
significant nontax benefit. Donors sometimes fear, often with some justice, that their gifts will not inspire
gratitude from the donees. A donative promise may partially allay such fears. In order to make a taxable gift
of a promise of money in the future, a donor has no choice but to demand, on the advice of counsel, that the
donees take actions that they might otherwise be reluctant to perform. For example, in consideration for a
$5.12 million note, the donees could, in principle, promise to keep kosher for the rest of the year, cancel
their subscription to The New York Times, visit their mother on Mother's Day, or read Ayn Rand's Atlas
Shrugged.
Finally, the donor could consider structuring the contract so that the note is payable to an irrevocable trust
for the benefit of the donees. For example, in exchange for a legally sufficient consideration from the
donees, a donor could promise to pay $5.12 million to a trust for their benefit. As a third-party beneficiary of
a contract is generally enforceable by the intended beneficiary, 45 it should be possible to structure the
contract so that the note is delivered to and is enforceable by the trustee of the trust, even if the
consideration is furnished by the beneficiaries. The beneficiaries should not, in that case, be considered to
have made an indirect gift to the trust, as the gift in
[pg. 10]
question will have been made by the donor rather than the beneficiaries. 46 In any case, even though the
beneficiaries provide the consideration for the gift, they will not thereby have acquired any property right
capable of being transferred (even indirectly) by gift. 47
If the note is payable to a trust created by the donor, it seems that the trust could be structured as a "grantor
trust" for income tax purposes. Even if the donor is legally obligated to deliver the note to the trustee, the
donor should still be considered the grantor of the trust for income tax purposes so long as the note is not
delivered for fair market value. 48 If the donor or certain other persons are also given powers or interests in
the trust described in Sections 673 through 677, the donor can be treated for income tax purposes as the
owner of the trust property. Consequently, neither the donor nor the trust should be taxed on the interest on
the note, as transactions between the donor and the trust are ignored for income tax purposes. 49 An
additional benefit is that, as discussed in further detail below, the donor should be able to allocate GST
exemption to the trust in order to reduce to zero the GST tax rate that may apply to any future
generation-skipping transfers with respect to the trust. 50
Satisfaction and refinancing of the note
Once a taxpayer has used up lifetime gift tax exemption by making a donative promise to pay money in the
future, the gift and estate tax consequences if the promise is later satisfied are benign. Suppose, for
example, that a taxpayer makes a binding promise to pay $5 million to his or her children in five years. If the
taxpayer ultimately pays $5 million to her children while the obligation is outstanding, the payment is not a
taxable gift. Both the courts and the IRS have held that the discharge of a binding obligation is not a taxable
gift. 51 Rather, a taxable gift is made, if at all, only when a legal obligation is created, not when it is actually
satisfied. 52 Thus, the payment of $5 million to the taxpayer's children in satisfaction of the taxpayer's debt is
not an additional taxable gift.
Now suppose that the taxpayer pays $2.5 million to his or her children two years after the promise is made
and dies the next year while the outstanding balance on the note is $2.5 million. Section 2053(c)(1)(A)
denies a deduction for the remaining $2.5 million debt. Under Rev. Rul. 84-25, however, the remaining debt
is not an adjusted taxable gift. Rev. Rul. 84-25 also holds that the satisfied portion is treated as an adjusted
taxable gift. However, as the $2.5 million partial repayment depletes the taxpayer's gross estate, it has no
effect on the total estate tax.
In contrast to discharging an existing debt, the consequences of permitting a debt to become
unenforceable-for example, after the lapse of a statute of limitations for enforcement of a note-are not at all
benign. Under Rev. Rul. 81-264, 53 the lapse of the statute of limitations for enforcement of a note is a
taxable gift by the lender to the borrower. 54 Suppose, for example, that a taxpayer makes a binding promise
to pay $5 million on demand to her children. Suppose, further, that under state law, if the children fail to take
steps to collect on the note within three years, the note becomes unenforceable. The children then take no
steps to enforce the note. Three years after the promise is made, the children under Rev. Rul. 81-264 would
be treated as having made aggregate taxable gifts to their mother of $5 million.
Avoiding reverse gift. There appear to be at least two ways to avoid an inadvertent "reverse" gift by the
donees:
[pg. 11]
(1) The promise could be structured as a long-term note with a maturity date that is expected to last
beyond the taxpayer's life expectancy. In that case, the note will not lapse until after the taxpayer's
death, at which time the note can be satisfied by the executors or personal representatives of his or her
estate without gift tax consequence. In some contexts, such as when a taxpayer receives a note as
consideration, the IRS may be less likely to respect a note whose term extends beyond an individual's
life expectancy. 55 As discussed above, however, a taxable gift should occur once a promise to pay
money or other property in the future becomes enforceable, regardless of whether the promise is bona
fide. Thus, that a note given gratuitously may not be due until after the donor's death should not prevent
the gift of the note from using up lifetime gift tax exemption. If a shorter term is selected or the promise
is structured as a demand note, care should be taken that the note is repaid in full before the statute of
limitations lapses.
(2) Prior to lapse of the statute of limitations, the note could be refinanced by having the promisees
agree to cancel the old note in exchange for a new note with a longer term. Given that notes are
presumed to be valued at face, the substitution of one note for another seemingly should not produce a
taxable gift. 56 On the other hand, the longer term of the new note may be a factor that makes it less
valuable than the old note, 57 which in turn could cause the promisees to be treated as having made a
part-gift, part-sale. In addition, if the new note is found not to be bona fide, the IRS may take the
position that the consideration received by the promisees in exchange for cancelling the old note is
valueless. 58 The promisees could then be treated as having made a gift of the entire loan amount.
Structuring the note. To mitigate these risks, it may be prudent to structure the new note so that its bona
fides are less open to question. For example:
• Regular interest payments should be required.
• The note should have a fixed due date that does not extend beyond life expectancy.
• Valuable security should be pledged. 59
In addition, on any refinancing of the obligation, the promisees should adequately disclose the transaction
on their gift tax returns. Under Reg. 301.6501-1(f)(4), if a transfer reported as not being a taxable gift is
adequately disclosed on a gift tax return, the statute of limitations for assessment of gift tax begins to run. If
the gift tax assessment period has expired, then, when calculating gift tax in later years or estate tax at
death, the IRS will not be able to treat the refinancing as a prior year gift. 60
GST tax consequences
Lastly, a taxpayer who makes a taxable gift in the form of a donative promise to pay money or other property
in the future should consider whether GST exemption can be allocated to the gift. For example, if the
promise is made to a trust, the property of the trust (including the debt obligation) can be subject to GST tax
if a GST occurs, unless sufficient GST exemption is allocated to the trust to produce an "inclusion ratio" of
zero. Normally, GST exemption can be allocated to any property of which an individual is the transferor. If a
transfer is subject to an "estate tax inclusion period" (ETIP), however, then GST exemption cannot be
allocated until the close of the ETIP. 61 An ETIP is generally any period during which any portion of the value
of the transferred property could be included (other than by reason of Section 2035) in the gross estate of
the transferor or the transferor's spouse. 62
At first blush, it seems that no ETIP results from a donative promise to pay money or other property in the
future. After all, unless the promise is made to a trust over which the donor retains interests or controls that
can cause gross estate inclusion at death, 63 the promise will not be included in the donor's gross estate.
Rev. Rul. 84-25, however, might be read to suggest that the note is included in the donor's gross estate
after all. "Since the note has not been paid," the ruling reasons, "the assets that are to be used to satisfy
[the] promissory note are a part of [the decedent's] gross estate." Thus, the gift "is deemed to be includible
in [the decedent's] gross estate." As
[pg. 12]
Rev. Rul. 84-25 deems the gift to be included in the gross estate, it may be that the ETIP rule will prevent
allocation of GST exemption.
Alternatively, a donative promise to pay money in the future could conceivably be recharacterized as a
transfer with a retained interest under Section 2036(a)(1). That section provides that the decedent's gross
estate includes all property, to the extent of any interest therein, in which the decedent at any time made a
transfer and retained for his or her life, or for a period not in fact ending before his or her death (or a period
not ascertainable without reference to his or her death), the right to the income, use, possession, or
enjoyment of the transferred property. 64
If Section 2036(a)(1) applies, such that the promise is deemed to be a "transfer" and the donor's right to
keep his or her assets until the note matures is deemed to be a retained "right to income, use, possession or
enjoyment," then, perhaps, property up to the amount of the note could be included in the donor's gross
estate under Section 2036(a)(1). In that case, the ETIP rule would prevent allocation of GST exemption.
That said, it seems that the ETIP rule should not in fact apply to a gift in the form of a promise to pay money
in the future. First, Rev. Rul. 84-25 only "deems" such a gift to be included in a decedent's gross estate and
then only for estate tax calculation purposes under Section 2001(b). It does not hold that the gift is literally
included in the gross estate under Section 2036 or any other section. Therefore, the IRS should not be able
to invoke the ETIP rule based on Rev. Rul. 84-25.
Nor should Section 2036(a)(1) apply to a gift in the form of a donative promise to pay money in the future.
To be sure, the gift is structurally very similar to a transfer described in Section 2036(a)(1). Suppose, for
example, that a taxpayer with $5.12 million of assets transfers all of her wealth to a grantor retained income
trust (GRIT) in which he or she retains the right to income for life. If the remainder is irrevocably payable to
members of the taxpayer's family, the value of the gift is, under the special valuation rules of Section 2702,
the full $5.12 million of assets transferred. At death, the entire trust will be included in the taxpayer's gross
estate under Section 2036(a)(1). The gift to the lifetime GRIT will not be an adjusted taxable gift, as it will be
included in the gross estate under Section 2036(a)(1). Thus, a lifetime GRIT can achieve the same goals as
a donative promise to pay money or other property in the future, in that it uses up gift tax exemption in 2012
and avoids an adjusted taxable gift at death.
Nevertheless, despite the structural similarities, a donative promise to pay money in the future should not
be characterized as a transfer with a retained interest described in Section 2036(a)(1). First, unlike a
taxpayer who funds a lifetime GRIT or who makes a gift of a remainder interest in property, a taxpayer who
makes a donative promise does not make a "transfer" of any of his or her assets. Without a "transfer,"
Section 2036(a) cannot apply. 65 Further, the application of Section 2036(a)(1) to a donative promise to pay
money in the future is inconsistent with Rev. Rul. 84-25. Rev. Rul. 84-25 "deems" such a promise to be
included in the gross estate purely for estate tax calculation purposes. If Section 2036(a)(1) already applied
to the gift, the holding of Rev. Rul. 84-25 would be superfluous.
Therefore, it seems that the IRS cannot treat a gift in the form of a promise to pay money in the future as a
transfer with a retained interest under Section 2036(a)(1). Consequently, the ETIP rule cannot apply, and
GST exemption can indeed be allocated to the gift. 66
Conclusion
Congress has given taxpayers a historic opportunity this year to make up to $5.12 million of lifetime gifts
without paying gift tax. Unfortunately, only the very wealthiest are likely to take advantage of the
opportunity. Even less affluent taxpayers, however, can make a taxable gift fairly painlessly by making an
enforceable promise to pay a substantial sum in the future. Such a promise, even in an intra-family situation
where there is little chance that the promise will be enforced, may, if enforceable, successfully use up the
increased gift tax exemption while it is still available.
1
To mitigate this risk, both spouses might create trusts for each other. However, such trusts could be
included in the spouses' gross estates at death if there was evidence of a prearranged plan to create
"reciprocal" trusts. Cf. Grace, 23 AFTR 2d 69-1954, 395 US 316, 23 L Ed 2d 332, 69-1 USTC ¶12609,
1969-2 CB 173 (1969) (holding that the reciprocal trust doctrine can apply even without a finding that the
transfer was made in a quid pro quo transaction).
2
See, e.g., Ltr. Rul. 200944002.
3
For convenience, this article refers to a promise to pay money or other property in the future, when made
for less than full and adequate consideration in money or money's worth, as a "donative promise." Such a
promise is "donative" in the sense that, if it is enforceable under local law, it will be treated as a taxable gift
for federal gift tax purposes. Section 2512; Rev. Rul. 84-25, 1984-1 CB 191. To be enforceable under local
law, however, a promise must generally be supported by some consideration, even if not adequate in dollar
terms.
4
An "adjusted taxable gift" is a gift made after 1976 that is not included in the gross estate. Section 2001(b).
5
Rev. Rul. 84-25, supra note 3; but see Rul. Rev. Rul. 67-396, 1967-2 CB 351 (holding that a gift of an
unenforceable note is not complete for gift tax purposes until it is actually paid).
6
Cf. Estate of Flandreau, 72 AFTR 2d 93-6711, 994 F2d 91, 93-1 USTC ¶60137 (CA-2, 1993) (suggesting,
in dicta, that an estate should be entitled to a credit under Section 2012 if a note transferred prior to 1977 is
not deductible under Section 2053).
7
Note 3, supra.
8
If the taxpayer gives away all of his or her wealth during lifetime, the $5.12 million consists of the sum of a
$0 taxable estate and the $5.12 million adjusted taxable gift. If the taxpayer make a donative promise to
give away all his or her wealth, the $5.12 million consists of the sum of the $5.12 million taxable estate and
$0 of adjusted taxable gifts.
9
For a comprehensive summary of the "clawback" issue, see Akers, "Estate Planning Effects and
Strategies Under the Tax Relief ... Act of 2010," NAEPC J. Estate & Tax Planning (Fourth Quarter, 2011).
See also M. Jones, Grasping Clawback's Applicability & Opportunities, LISI Estate Planning Newsletter
#1925 (2/16/2012).
10
P.L. 107-16 § 901, as amended by P.L. 111-312 101(a)(1); P.L. 111-312 § 304.
11
While the sunset provisions may compel a taxpayer-friendly result in the context of clawback, they may
compel taxpayer-unfriendly results in other areas. For example, some GST exemption allocations made
post-EGTRRA may "disappear" after 2012 and "qualified severances" of trusts for GST tax purposes could
be disregarded.
12
It is not clear whether the donees would be personally liable for the recaptured tax if the donor does not
survive three years from the gift. See generally Zaritsky, Practical Estate Planning in 2011 and 2012
(Thomson Reuters/WG&L, 2011), ¶ 4.02[1][d].
13
In the same legislation that created the clawback issue for some decedents dying after 2012, Congress
also enacted new portability provisions (permitting a surviving spouse to use the unused estate and gift tax
exemption of the deceased spouse) that create a clawback issue for some decedents who survive multiple
spouses. That Congress did not foreclose the possibility of clawback in the context of portability suggests,
indirectly, that Congress intended for the IRS to be able to recapture tax on lifetime gifts made in
2011-2012.
14
See also Reg. 20.2043-1(a).
15
For example, if a taxpayer attempts to make a "painless" taxable gift by giving away property and
thereafter borrowing from the donees, there is a risk that the debt obligation will not be deductible at death
under Section 2053(a)(3) or that the donee-lenders will be deemed to have made taxable gifts of the
amount loaned. Rev. Rul. 77-299, 1977-2 CB 343.
16
To qualify for the "parenthetical" exception to gross estate inclusion under Sections 2036 and 2038,
property must be transferred not only for full and adequate consideration in money or money's worth but
also in a bona fide sale.
17
See also Reg. 25.2512-8.
18
Cf. Reg. 25.2512-8.
19
42 TC 936 (1964), acq. in result 1965-1 CB 4, nonacq. 1977-2 CB 2.
20
See also Estate of Kelly, 63 TC 321 (1974), nonacq. 1977-2 CB 2; but see Miller, TC Memo 1996-3, RIA
TC Memo ¶96003, 71 CCH TCM 1674 , aff'd113 F.3d 1241, 79 AFTR2d 97-2843 (CA-9, 1997) ("The mere
promise to pay a sum of money in the future accompanied by an implied understanding that such promise
will not be enforced is not afforded significance for Federal tax purposes....").
21
Note 15, supra.
22
33 AFTR 584, 324 US 303, 89 L Ed 958, 45-1 USTC ¶10179, 1945 CB 416 (1945).
23
In Wemyss, supra note 22, for example, the taxpayer's fiancé was reluctant to marry him, as the marriage
would cause her to lose the income from two trusts created by her late first husband. To induce her to marry
him, the taxpayer agreed to transfer certain shares of stock to her.
24
The general period for assessment of gift tax is three years. Section 6501(a).
25
Section 2001(f). The value of the gift becomes "finally determined" for this purpose if the IRS does not
contest the reported value within the assessment period. Section 2001(f)((2)(A); Reg. 20.2001-1(c)(1). For
a detailed discussion of these "finality" rules, see Bramwell, "Considerations and Consequences of
Disclosing Non-Gift Transfers," 116 J. Tax'n 19 (January 2012).
26
Reg. 301.6501-1(f)(5).
27
See Reg. 301.7477-1(b) (authorizing the IRS to contest the reported value of a taxable gift even where no
gift tax is due).
28
Reg. 25.2512-1.
29
See also Prop. Reg. 25.2512-4 ("The fair market value of notes, secured or unsecured, is presumed to be
the amount of unpaid principal, plus accrued interest, unless the donor establishes a lower value.").
30
If there is a market for the note, then the trading price on the market would need to be used to determine
the note's value. Reg. 25.2512-2. However, there will typically be no market for intra-family notes.
31
Section 2001(f).
32
A below-market term loan is a term loan for which the amount loaned exceeds the present value of all
payments due under the loan. Section 7872(e)(1)(B). "Present value" is determined using a discount rate
equal to the applicable federal rate. Section 7872(f)(1)(B).
33
See Frazee, 98 TC 554 (1992) (holding that, where property is sold in exchange for term notes, the
amount of the gift equals the excess of the property transferred over the present value of all payments
which are required under the terms of the loan); see also Prop. Reg. 25.7872-1 ("For [gift tax] purposes ... if
a taxpayer makes a gift loan ... that is a term loan ... the excess of the amount loaned over the present value
of all payments which are required to be made under the terms of the loan agreement shall be treated as a
gift from the lender to the borrower on the date the loan is made.").
34
Cf. Prop. Reg. 1.7872-1(a)(1) ("For purposes of section 7872, the term 'loan' includes generally any
extension of credit ... and any transaction under which the owner of money permits another person to use
the money for a period of time after which the money is to be transferred to the owner or applied according
to an express or implied agreement with the owner.").
35
See Frazee, supra note 33 ("[The IRS] urges as her primary position the application of section 7872 [in
order to value a term note], which is more favorable to the taxpayer than the traditional fair market value
approach, but we heartily welcome the concept"); Ltr. Rul. 9535026; cf. Blackburn, 20 TC 204 (1953)
(holding that the value of a note should be determined in part by comparing the interest rate on the note and
the prevailing rate of interest for similar transactions in the marketplace).
36
Rev. Rul. 67-396, supra note 5.
37
In Dickerson, TC Memo 2012-60, RIA TC Memo ¶2012-060, 103 CCH TCM 1280 , for example, the
taxpayer attempted to avoid a taxable gift of lottery winnings on the theory that she was required to transfer
the winnings pursuant to a binding contract with the donees. The court held, on the contrary, that no
enforceable contracted existed, as contracts founded on a gambling consideration were void under
applicable state law. Thus, the court held that the transfer of the winnings was not made in discharge of a
contractual obligation but rather in a taxable gift.
38
11 Am. Jur. 2d Bills and Notes § 2; see also Uniform Commercial Code 3-303Uniform Commercial Code
3-303.
39
The traditional elements of a contract are multiple parties, offer and acceptance, and consideration.
40
11 Am. Jur. 2d Bills and Notes § 129.
41
11 Am. Jur. 2d Bills and Notes § 128.
42
Hamer v. Sidway, 27 NE 256 (N.Y., 1891).
43
Restatement (Second) of Contracts § 71 comment c.
44
Restatement (Second) of Contracts § 79 comment c.
45
Restatement (Second) of Contracts §§ 304 and 346 comment c.
46
In a related context, Regulations provide that where a gift is made through an intermediary, only one gift by
the donor (and not the intermediary) is made. Reg. 25.2511-1(h)(2). In other words, even where a third
party is involved in a transfer from the donor or the donee, only one taxable gift occurs, not two. But see
Johnstone, 15 AFTR 382, 76 F2d 55, 35-1 USTC ¶9198, 1935-2 CB 346 (CA-9, 1935) (creating a potential
for double taxation in virtue of its holding that trust assets were included in the decedent's gross estate
where the decedent held a general power of appointment that could have been extinguished at any time by
the settlor).
47
Cf. Estate of DiMarco, 87 TC 653, 7 EBC 2239 (1986) (holding that a taxable gift did not occur merely
because an employer paid a benefit to a third party in exchange for an individual's services as employee).
48
Reg. 1.671-2(e)(2).
49
Rev. Rul. 85-13, 1985-1 CB 184.
50
See Sections 2631-32.
51
Copley, 41 AFTR 705, 194 F2d 364, 52-1 USTC ¶10843 (CA-7, 1952), acq'd 1965-2 CB 4.
52
Rosenthal, 44 AFTR 90, 205 F2d 505, 53-2 USTC ¶10908 (CA-2, 1953) ("[A] binding promise to make a
gift becomes subject to gift taxation in the year the obligation is undertaken and not when the discharging
payments are made."); Rev. Rul. 84-25, supra note 3 ("[A] completed gift [was made on] the date on which
D's promise was legally binding and determinable in value").
53
1981-2 CB 185.
54
See also Estate of Lang, 64 TC 404 (1975).
55
See, e.g., Ltr. Rul. 9206006 (ignoring a note that decedent's daughter gave to decedent, based in part on
the fact that the term of the note exceeded the decedent's life expectancy).
56
For a thorough discussion of this issue, with a focus on the consequences of substituting notes with lower
interest rates, see Blattmachr, Crawford, and Madden, "How Low Can You Go? Some Consequences of
Substituting a Lower AFR Note for a Higher AFR Note," 109 J. Tax'n 22 (July 2008).
57
Reg. 25.2511-4 (listing "date of maturity" as a possible discount factor); Blackburn, 20 TC 204 (1953)
(valuing a note received as consideration for property at less than face where the note would not mature for
34.5 years).
58
See Rev. Rul. 77-299; Miller, TC Memo 1996-3, RIA TC Memo ¶96003, 71 CCH TCM 1674 , aff'd113 F.3d
1241, 79 AFTR2d 97-2843 (CA-9, 1997).
59
These factors, and others, support a finding that a debt obligation is bona fide. See, e.g., Miller, supra note
58; Rosen, TC Memo 2006-115, RIA TC Memo ¶2006-115, 91 CCH TCM 1220 ; Estate of Duncan, TC
Memo 2011-255, RIA TC Memo ¶2011-255, 102 CCH TCM 421 .
60
Sections 2001(f), 2503(c). See generally Bramwell, supra note 25.
61
Section 2642(f).
62
Reg. 26.2632-1(c)(2)(i).
63
For example, in Estate of Tiffany, 47 TC 491 (1967), a decedent transferred property to a trust and
thereafter caused the property to be lent back to her. The decedent retained the power to terminate the trust
and to make equal or unequal distributions to the beneficiaries. Although the case was decided on other
grounds, the IRS argued, apparently correctly, that the loans should be included in the gross estate under
Section 2038(a).
64
Section 2036(a) contains an exception in the case of a bona fide sale for full and adequate consideration
in money or money's worth.
65
See, e.g., Estate of Cleveland, TC Memo 1983-227, PH TCM ¶83227, 45 CCH TCM 1403 (holding that
assets of a trust for the benefit of a decedent were not included in her gross estate under Section 2036(a)
solely because she loaned to the trust income that was otherwise distributable to her).
66
A donative promise to pay money or other property in the future is a superior technique for using up
lifetime gift tax exemption for other reasons. First, with a donative promise, a taxpayer can retain access to
both income and principal. With a lifetime GRIT, by contrast, a retained interest in principal may cause the
entire gift to be incomplete on the theory that the donor could relegate creditors to the trust principal under
state law. See, e.g., Paolozzi, 23 TC 182 (1954). Second, returns on a donative promise in the form of
accrued interest can pass free of estate tax to the promisees. A lifetime GRIT, by contrast, will be included
the grantor's gross estate under Section 2036(a)(1).
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