Donee Gets Income Tax Deductions for Medical Expenses and Taxes

Judith F. Lang v. Commissioner, TC Memo 2010-286

From time to time I encounter confused people.  They might for example think that they can give $13,000 to each of their kids and deduct it.  That's not the way it works.  The $13,000 is the amount that you can give to as many individuals as you want to - including me by the way (I'll tell you where to mail the check) - without having a taxable gift (Under the new regime, you can have $5,000,000 in taxable gifts before you have to start paying gift tax).  Gift tax is the responsibility of the person making the gift.  Income tax is the responsibility of the person receiving taxable income, which does not include gifts.  So what happens if your aunt gives you $10,000,000 of low basis stock, but wants you to pay the gift tax for her ?  You and your aunt can give me a call and I'll work with you on it.  This post is about something that happens with the merely wealthy.

The annual exclusion is not the only exclusion from gift tax.  There is also an exclusion for gifts made for medical or educational purposes.  In order to qualify for the exclusion the donor must pay the bills directly.  So if you pay the medical bills of your adult children those payments are excluded for gift tax purposes (i.e. You can give the ne'er do wells who can't pay their own medical bills $13,000 in cash on top of that without eating into your $5,000,000.  They'll still probably resent you, but you'll need to find another blog to deal with those issues.)

Medical expenses are also deductible for income tax purposes, though.  What is supposed to happen for income tax purposes when your medical bills are paid by someone else ? Judith Lang had some heavy medical expenses and was behind on her real estate taxes.  Fortunately, she had a generous Mom :

Petitioner's mother, Frances Field (Mrs. Field), paid $24,559 directly to medical providers on account of petitioner's medical expenses and paid $5,508 directly to the city government on account of petitioner's real estate tax. Petitioner was not a minor, and Mrs. Field was not legally obligated to pay petitioner's expenses.


Ms. Lang thought that she should be able to deduct these payments for income tax purposes:

It is petitioner's position that although Mrs. Field made the payments directly to petitioner's creditors, we should consider them to have in substance passed from Mrs. Field to petitioner and then to petitioner's creditors; therefore petitioner should be entitled to deduct the payments.

The IRS did not agree:

Respondent contends that the form of the transaction should apply and that because the money was paid directly from Mrs. Field to petitioner's creditors, petitioner may not claim the deductions.

The Tax Court noted that the IRS did not claim that Ms. Fields had deducted the medical expenses only that Ms. Lang was precluded from deducting them because she had not paid them.

The Tax Court ruled in favor of the taxpayer with respect to both the medical expenses and the real estate taxes.  With respect to the medical expenses they noted:

Although Mrs. Field and petitioner would not be subject to the gift tax,  the income tax treatment in this context is not controlled by the gift tax consequence.

Petitioner should be credited with having made the payments for purposes of the income tax deduction in question.



With respect to the real estate taxes the issue was even clearer:

Mrs. Field paid $5,508 directly to the city government in discharge of petitioner's obligation for real estate tax. Again applying substance over form, we treat petitioner as having received from her mother a gift of the $5,508 with which petitioner paid the city in satisfaction of her own real estate tax. Thus petitioner is entitled to a deduction under section 164 for that amount.


We note that there is no danger of a “double deduction” arising from our decision on this issue. See Rome I, Ltd. v. Commissioner, 96 T.C. 697, 704 (1991) (”Double deductions are impermissible *** absent a clear declaration of intent of Congress.”). Because the real estate tax was imposed upon petitioner, she is the only taxpayer who may deduct it; Mrs. Field may not. See sec. 1.164-1(a), Income Tax Regs.

This is a significant decision for some wealthy families where transfer tax concerns outweigh income tax concerns.  It would be a good idea to review the individual returns of family members who have benefited from gift tax excludable medical gifts.

FLP Good for the Family Business - But Maybe not the Family Jewels

JOHN W. FISHER and JANICE B. FISHER, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.09/01/2010


The family limited partnership is a fairly robust estate planning tool.  It has been under attack for some time, but generally stands up pretty well.  The IRS objection to it is understandable.  Somehow it seems that taking a bunch of stuff and putting the stuff into an entity should not produce a whole that is of lesser value than the sum of its parts.  It makes one wonder whether intellectual integrity is a key element in successful tax practice.  On a really bad day it makes one wonder whether lack of intellectual integrity might be a requirement.

The Fishers formed a Limited Liability Company (LLC) called Good Harbor Partners LLC.  Its principal asset was a tract of undeveloped land that bordered Lake Michigan.  In 2000, 2001 and 2002, they gave 4.762% interests in the LLC to each of their children. The Good Harbor operating agreement has significant restrictions on the transferability of interests.  The IRS argued that the restrictions on transferability should not be considered because the LLC did not constitute a bona fide business arrangement.  The court agreed stating :

The facts of this case are analogous to those in Holman . There, two donors created a limited partnership, funded it with common stock from a publicly traded company, and gifted limited partnership shares to their children. 601 F.3d at 765. There was no evidence indicating that the partnership employed a particular investment strategy or that the donors were “skilled or savvy investment managers whose expertise [wa]s needed or whose investment philosophy need[ed] to be conserved or protected from interference.” Id. at 770, 771. The donors retained exclusive control of the partnership, and their children could not withdraw from the partnership or assign their interests unless certain transfer conditions were met. Id. at 766. The Eighth Circuit affirmed the Tax Court's conclusion that the restrictions upon the children did not serve a bona fide business purpose because the partnership was not a ““business,” active or otherwise.” Id. at 770. In so holding, the Holman court distinguished a line of cases where active, ongoing business interests were preserved by the transfer restrictions at issue.See, e.g., id. at 771 (“The underlying assett in [Estate of] Bischoff [v. Comm'r, 69 T.C. 32, 39–40, 1977 WL 3667 (1977)] was a pork processing business organized, controlled, and managed by three families who sought to assure their continuing ability to carry on their pork processing business without outside interference, including that of a dissident limited partner.”).

This case is troubling in that there doesn't appear to be any of the sloppy execution that is common in failed family limited partnership.  It appears to call into question the use of this technique in the case of a single asset that does not have business characteristics.

Devil is in The Details

In June of 2007, the Estate of Sylvia Gore joined the ranks of failed Family Limited Partnership. The case is worthy of consideration, because it illustrates clearly why the partnerships fail. If you are going to set up a family limited partnership it is critical that you consult with a well qualified attorney. The attorney will create a package, more or less thick, of documents, more or less mysterious and will see that you sign them with witnesses, notarized, with an extra copy in her safe in case you lose yours. That’s service. That’s follow through. Valuation discounts are what tends to be at stake when the IRS attacks Family Limited Partnerships. Having had great service from your attorney, you probably think that when people lose it is because they didn’t hire a good attorney. Perhaps the documents weren’t witnessed. Maybe one of the incantations in the mysterious documents was missing. Maybe there wasn’t an extra copy in the safe, after they lost theirs.

The follow through needed is not the extra hour in the attorney’s office. The follow through will be many hours year in and year out in your accountant’s office. The clue to this is in the importance attributed to the extra copy in the attorney’s safe. Why doesn’t the accountant who has to prepare the income tax return for the partnership have a copy? Why don’t you need to look at your copy from time to time too? Here’s why:

each partner's capital account is increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain (or items thereof), including income and gain exempt from tax and income and gain described in paragraph (b)(2)(iv)(g) of this section, but excluding income and gain described in paragraph (b)(4)(i) of this section; and is decreased by (4) the amount of money distributed to him by the partnership, (5) the fair market value of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), (6) allocations to him of expenditures of the partnership described in section 705(a)(2)(B), and (7) allocations of partnership loss and deduction (or item thereof), including loss and deduction described in paragraph (b)(2)(iv)(g) of this section, but excluding items described in (6) above and loss or deduction described in paragraphs


This is one of the magic incantations that will appear in your agreement. If you ask your attorney how that paragraph should be reflected on the partnership’s tax return, he is likely to tell you that he doesn’t prepare partnership returns. That’s what accountants do. Now go to your accountant and ask her what that paragraph means. Among the possible answers are “That’s some stuff the attorneys have to put in the agreement. Why don’t you ask him what it means?”

So what did Sylvia Gore and her advisers do or fail to do that cost the estate $1,071,650 in federal estate taxes. Plus ten years of interest. Not to mention the cost of their fruitless efforts in the Tax Court.

In 1995 Sydney Gore met with his accountant in the hospital where he expressed to her “his concerns about preserving the wealth he had accumulated through his life's work, protecting his assets from waste, and conserving them for future generations”. The accountant had an idea, a very good idea. Form a family limited partnership. She’d never advised any of her other clients to take that step, but it seemed to the right thing to do here. She knew that she had limits, though:

“Ms. Bowers had little experience with family limited partnerships and had never recommended one to a client before she made the proposal to the Gore children, so she recommended that Ms. Powell, Mr. Gore, and decedent retain an attorney to further advise them about a limited partnership”

Apparently it didn’t occur to anybody that an accountant with more than a little experience with family limited partnerships might be able to bring something to the table.

What happened from here can hardly be blamed on the accountant. The partnership opened a bank account into which substantial sums were deposited. There was an assignment of marketable securities to the partnership. Unfortunately, title to the securities was not transferred to the partnership. The dividends from the securities were not deposited in the partnership’s bank accountant. When Mrs. Gore’s bills need to be paid they were paid sometimes from her personal accounts other times from partnership accounts.

Eventually returns need to be filed, which is when Ms. Bowers came back on the scene. What she did was what most competent accountants would try to do. Observing that what actually happened was not anything near like what was supposed to happen, she attempted to fix it all with journal entries. This process relies on one of the great intellectual breakthroughs that built the modern world – double entry bookkeeping first documented in a mathematical treatise over 500 years ago. It provides a built-in check that shows that you captured everything. It all has to balance. Debits equal credits.

When a check is written we credit cash. Then we have to debit something. Well the check went to Mary, so we debit Mary’s capital account. Unfortunately, by the terms of the partnership agreement we were not supposed to make a distribution to Mary. So we debit “Due from Mary”. Joe, on the other hand was supposed to get a distribution. Well either we won’t worry about that since it’s reflected in Joe’s capital or, if we want the percentages to be where they should be, we will credit “Due to Joe” and debit his capital account. When it’s all done the amounts on our records will agree to the statements (adjusted for the fact that they may not have the right names on them) and “it will all balance.” Mary will owe the partnership and the partnership will owe Joe. We’ll straighten it out next year or we’ll keep making journal entries to keep it straight.

I have learned a hard lesson that many accountants never quite get. When it comes to this “everything’s in balance” routine, almost nobody else cares. Here is some of what the court had to say about Ms. Bower’s efforts:

“The GFLP accounting records prepared by Ms. Bowers purport to show that decedent transferred ….”

“The accounting records also purport to show that after decedent executed the assignment, decedent allegedly sold the Commercial Federal CD, the savings bonds, a Valley National CD, and one of the Treasury notes to GFLP in exchange for a note payable to her from GFLP …”

The word “purport” or one of its forms (e.g. “purporting”) occurs six times. Here is the problem. You can get into law school with a liberal arts degree. They don’t teach double entry accounting in law school. If it’s taught in high school, it’s to kids not on the college track. You certainly don’t need it for a liberal arts degree. Judges are lawyers. It all balances and they don’t care.

I have no reason to doubt that if I looked at all the statements and agreements, I’d have concluded that Ms. Bower’s journal entries straightened things out. Likely most other accountants would reach a similar conclusion when they see that the cash ties and “it balances”. Much to our professional frustration, almost nobody else, but especially the judge, cares. The meticulous journal entries that “straighten” everything out in our minds, in the mind of the judge “purport”.

Also this year, the Estate of Concetta Rector lost to the tune of $1,633,049 plus about five years of interest. Here is an excerpt:

“The estate attempts to downplay the significance of the direct use of RLP funds to pay decedent's personal expenses by attributing that use to “errors”. In the light of John Rector's extensive financial expertise and his testimony that it never occurred to him that RLP should be reimbursed for such “errors” after they were discovered, we find that this argument lacks credibility”
This is nothing new. If you study the cases where taxpayers lose FLP cases, you will, almost always, if not inevitably, find that the failure was not one of a flawed plan. The failure was not following the steps transaction by transaction. If somebody is entitled to a distribution and has bills to pay, you distribute to them and let them pay their own bills. All entities have accounts and the payments in and out are the ones that belong to that entity. If a mistake is made it is fixed by a transfer of funds, not a journal entry that creates an indefinite “Due to”.
The moral of the story is that in order for the plan to work you must have coordination between the attorney who prepares the plan and the accountant who will be preparing the relevant returns. If you don’t want to trouble yourself with what entity should pay what bill or accept what deposit, etc, let that piece be handled by your professionals, also, but again in an integrated manner. There has to be somebody who cares what account is used, because that is their job.