Monday, March 21, 2011

Thanksgiving Without Mom Almost Costs $3,000,000

Estate of Sylvia Riese, et al. v. Commissioner, TC Memo 2011-60

One of the things I often say about sophisticated estate planning techniques is that when they fail, it is often a failure of execution rather than conception.  Someone comes up with a sound plan, the documents that will execute the plan are drafted and then somewhere along the line things are not executed in accordance with the plan.  In this case the taxpayers came out OK anyway, but it still represents a cautionary tale.

The case concerns a QPRT - (Qualified Personal Residence Trust).  The technique allows a taxpayer to make a gift of a future interest in their residence.  During the term of the trust they continue to live in it and are treated for income tax purposes as if they own it.  At the end of the term it is treated as being owned by the benerficiaries or a trust for their benefit.  The advantage of the arrangement is that the donor gets to use todays value of the residence (and we all know real esate only goes up).  In addition since it is ownership of the house in the future that is being gifted the value is discounted to take into account the time value of money. (Remember when money used to earn interest).  The disadvantage is that at the end of the term the donor has to start paying rent, if she wants to keep living in the house.  The purpose of the preceeding discussion is to give context for this cautionary tale.  It is not a comprehensive discussion of the QPRT technique.

Mrs. Riese appears to have had some good estate planning done for her:

Mr. Tucker represented decedent with regard to estate planning and other matters.  In 1999 Mrs. Grimes mentioned to him that decedent was agreeable to some additional estate planning with respect to the residence. In response, Mr. Tucker and Mrs. Grimes began considering the establishment of a QPRT for decedent. Mr. Tucker sent a letter dated September 17, 1999, to Mrs. Grimes explaining the Federal gift tax costs and some of the benefits of establishing a QPRT for decedent. Mrs. Grimes then visited decedent and explained the contents of the letter to her. Decedent asked Mrs. Grimes whether she would directly benefit from the establishment of a QPRT. Mrs. Grimes explained that establishing a QPRT would result in a lower estate tax liability but also that decedent would have to pay gift tax on the transfer and pay rent to live in the residence after the QPRT expired. Decedent agreed that a QPRT would be acceptable and gave Mrs. Grimes permission to proceed.

There was good execution on the front end:

On April 19, 2000, decedent established the Sylvia Riese QPRT (the QPRT) under section 25.2702-5, Gift Tax Regs., and executed a deed transferring the residence thereto. Decedent reported the transfer of the residence to the QPRT on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for tax year 2000.

Things went awry when the trust reached its termination date.  At that point the trust should have deeded the property to the remainder beneficiaries (new trusts in this case).  The new owner or owners then should have taken responsbibility for paying all expenses related to the property.  Since Mrs. Riese was still living in the property she should have signed a lease and started paying rent.  That's not exactly what happened.

The QPRT agreement states, in pertinent part, that if the settlor (i.e., decedent) survives the termination date of the QPRT, the QPRT shall terminate and the balance of the trust fund (i.e., the residence) shall be distributed 50 percent each to two trusts, known as the 1997 Property Trusts (the Property Trusts), which decedent established in 1996 for the benefit of Mrs. Grimes and Ms. Zipp. The QPRT terminated by its terms on April 19, 2003. Decedent (or the QPRT) did not execute a deed transferring the residence to the Property Trusts.

Mrs. Grimes never discussed rent directly with decedent after the QPRT terminated. However, around the termination date Mrs. Grimes called Mr. Tucker inquiring about how to determine the proper amount of rent to charge decedent. She testified: “I knew she'd agreed to it and, you know, I didn't—I didn't want to feel like I was badgering her. And so I called *** [Mr. Tucker].” Mr. Tucker explained to her that fair market rent could be determined by contacting local real estate brokers and that this could be done by the end of the year (i.e., December 31, 2003). Mr. Tucker entered a “tickler” in his pocket calendar to remind himself to call Mrs. Grimes by Thanksgiving to make sure everything was taken care of.

The significance of Thnaksgiving is unclear.  Perhaps the plan was to get Mom to sign a rent check before the turkey was carved.  Sadly, Mrs Reis did not even make it to Haloween as she suffered a stroke and died on October 26, 2003.  She would not be able to sign a rent check covering the period that she was a tenant rather than an owner as the ball descended in Times Square as Mr. Tucker apparently had planned.

It is unusual for landlords to let people live in a house for 6 months without paying any rent.  The IRS contended that Mrs. Reis had not really given the house away.  People realize that they can't take it with them, but their preference is to control it till slightly before their last breath and then have it go to their heirs without being included in their taxable estate.  There are laws in place to frustrate this natural desire and the laws will take note of implicit understandings.

The Tax Court ended up cutting the family quite a bit of slack:

We find as a matter of fact that there was an agreement among the parties for decedent to pay fair market rent, the amount of which was to be determined and payments to begin by the See Diaz v. Commissioner, 58 T.C. 560, 565 (1972) end of 2003. (basing analysis upon evaluation of the entire record and credibility of witnesses). The Secretary had not issued any regulations or guidance as to how and when rent should be paid upon the termination of a QPRT. We believe that doing so by the end of the calendar year in which the QPRT expired would have been reasonable under the circumstances.

Unlike many cases involving the transfer of a personal residence where the decedent continued to live in the residence until death, see, e.g., Estate of Van v. Commissioner, T.C. Memo. 2011-22 [TC Memo 2011-22], the existence of an implied agreement in this case is negated by the express agreement among the parties for the payment of rent. Many factors, e.g., the creation of the QPRT, the payment of gift tax upon the transfer of the residence to the QPRT, the several instances in which decedent agreed to pay rent, the fact that Mrs. Grimes called Mr. Tucker upon the QPRT's termination to find out how to determine the amount of rent to charge, and Mr. Tucker's corroborating testimony, all lead us to find that there was no agreement or understanding that decedent would retain an interest in the residence for life without paying rent.

We believe that Mrs. Grimes, on the advice of counsel, intended to and would have determined fair market rent by the end of 2003 and decedent would have paid rent. We believe further that Mr. Tucker would have made sure a lease was executed, rent was determined, and all appropriate changes were made to effect the change of ownership. Unfortunately, decedent died unexpectedly in October before any of this occurred.

There was a deficiency of over $3,000,000 involved in this case so I'm willing to wager that the litigation cost was substantial.  Although the taxpayer prevailed (They lost on some other small issues) it must have been kind of nerve racking.  It could have been avoided if when the gift was made in April of 2000, a plan had been made to sit down with Mrs. Reis in say February of 2003 to go over what would be happening in the next couple of months.  The rent determination, the transfer, the lease and the initial rent payment should have all been done in April 2003.

Other practitioners might read this case and come to the opposite conclusion saying that it proves that waiting till the end of the year to clean everything up is just fine based on:

The Secretary had not issued any regulations or guidance as to how and when rent should be paid upon the termination of a QPRT. We believe that doing so by the end of the calendar year in which the QPRT expired would have been reasonable under the circumstances.

I would disagree with that analysis.  There is no reason to take chances like that with so many dollars at stake.

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