Brown v. U.S.

• Decision Date: 01 May 2003
• Docket Number: No. 02-55254.,02-55254.
• Citation: 329 F.3d 664
• Parties: Betty R. BROWN; Michael J. Brown; Philip A. Melrose; Beryl Rae, as Co-Trustee of the Marital Trust Created under the will of Willet H. Brown; Raymond C. Sandler, as Co-Trustees of the Marital Trust Created Under the Will of Willet H. Brown, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

329 F.3d 664

Betty R. BROWN; Michael J. Brown; Philip A. Melrose; Beryl Rae, as Co-Trustee of the Marital Trust Created under the will of Willet H. Brown; Raymond C. Sandler, as Co-Trustees of the Marital Trust Created Under the Will of Willet H. Brown, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 02-55254.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted February 4, 2003.

Filed May 1, 2003.

COPYRIGHT MATERIAL OMITTED

Charles L. Birke, Sandler and Rosen, LLP, Los Angeles, CA, for the plaintiffs-appellants.

Judith A. Hagley, Tax Division, Department of Justice, Washington, DC, for the defendant-appellee.

Appeal from the United States District Court for the Central District of California; Gary A. Feess, District Judge, Presiding. D.C. No. CV-99-05437-GAF.

Before MESKILL,^* FERGUSON, and BERZON, Circuit Judges.

OPINION

BERZON, Circuit Judge:

The estate tax combines into one sad transaction the only two certainties in life. Upon death, a decedent's estate must pay a tax on property owned immediately prior to death, subject to certain adjustments. 26 U.S.C. § 2001 et seq.¹

This appeal involves three of those adjustments. First, we must determine whether the Internal Revenue Service ("IRS") properly increased the estate tax owed by the estate of Willet Brown ("the Estate") under § 2035(c)(1993), a provision which increases the estate tax to account for gift taxes paid in the three years immediately prior to death. To answer that question, we must consider whether the IRS was entitled to apply the "step transaction" doctrine, treating gift taxes paid by Betty Brown as if paid by Willet Brown. The district court determined that the IRS properly ascribed the payment of the gift taxes to Willet Brown, as do we.

The second, more complex issue involves the interaction of two estate tax deductions: the marital deduction (§ 2056) and the administration expense deduction (§ 2053(a)(2)). The Estate argues that it is entitled to increase the administration expense deduction to account for higher-than-expected administration expenses. The IRS agrees, but argues that any increase in that deduction must by offset by a corresponding decrease in the marital deduction to the extent that expenses were paid out of funds otherwise earmarked for the marital trust. The district court ruled in favor of the IRS. We affirm on that issue as well.

BACKGROUND

Willet Brown ("Willet") died in 1993, leaving behind a sizeable estate, worth approximately $180,000,000. Pursuant to a pre-nuptial agreement between Willett and wife Betty Brown ("Betty"), the entire estate was Willet's separate property, California community property laws notwithstanding.

(A) The Estate Tax Plan

Prior to his death, Willet sought the advice of an estate tax attorney. Together, the two developed a plan pursuant to which Willet's entire net estate would be placed in a marital trust upon his death. During her life, Betty would be the income beneficiary of this marital trust. Through the operation of the marital deduction rules of § 2056 this arrangement allowed Willet both to provide financial stability to Betty and to defer the collection of estate taxes until after Betty's death. See Brown v. United States, 2001 WL 1480293, 88 A.F.T.R.2d.2001-6665, *1 (C.D.Cal.2001).

As part of this plan Willet also created an insurance trust to hold life insurance on Betty's life, presumably so that the heirs receiving the estate property upon her death could use the life insurance proceeds to pay estate taxes. To fund the life insurance trust Willet gave Betty a gift of $3,100,000. Betty promptly wrote a check from her separate checking account for that amount in favor of the life insurance trust.

Whether the $3,100,000 was paid by Betty or Willet is immaterial to the current appeal. The parties agree that the $3,100,000 payment into the life insurance trust was a taxable event, incurring gift tax liability of $1,415,732. They further agree that Willet and Betty properly elected to be jointly and severally liable for the gift taxes under § 2513(a) & (d).

At issue is whether Willet or Betty paid the gift taxes. If the spouse who paid the gift taxes died within three years of doing so, § 2035(c)(1993) would require that spouse's estate to pay estate taxes on the $1,415,732 in gift taxes.² As Willet died within three years of the payment, it is preferable to the Estate that Betty be considered the individual who paid the gift tax.

We here pause to explain why the IRS would require a decedent to pay estate taxes on gift taxes, a concept that, on its face, gives new meaning to the phrase "double taxation." Section 2035(c)(1993) is designed to recoup any advantage gained by so-called "death-bed" transfers in which a taxpayer, cognizant of impending mortality, transfers property out of her estate in order to reduce estate tax liability. See Block v. United States, 507 F.2d 603, 605 (5th Cir.1975) (discussing predecessor of the current § 2035). Although these inter vivos transfers incur gift tax liability, opting to transfer assets prior to death still carries a tax advantage.³ Gift tax is calculated using a tax exclusive method (the applicable rate is applied to the net gift, exclusive of gift taxes), whereas estate taxes are calculated on a tax inclusive method (the applicable rate is applied to the gross estate, before taxes are deducted).⁴ Section 2035(c)(1993) presumes that gifts made within three years of death are made with tax-avoidance motives and eliminates the tax advantage for those death bed transactions.

Back to our story: Willet and his attorney realized at the time of the life insurance trust transaction, that in light of § 2035(c)(1993), it was a better actuarial bet for Betty, rather than Willet, to pay the gift taxes. True, if Betty paid the gift taxes and then died within three years of doing so, her estate might owe estate taxes on the gift taxes through the operation of § 2035(c)(1993). But Betty, age 71, was more likely to outlive the 3-year reach of § 2035(c)(1993) than was Willet, age 87. A good plan, but the couple faced a practical problem: Betty had little money of her own and was therefore unable to make the necessary payments from her separate property.

So Willet, on the advice of his estate tax attorney, gave Betty two checks totaling $1,415,732, which she deposited in her own account. The next day she drew two checks from her personal account payable to the IRS for the identical amount, in satisfaction of the gift tax liability. (Because gifts between spouses are tax free, the gifts from Willet to Betty enabling this actuarial wager did not otherwise risk any gift or estate tax liability.) As the Brown estate admits, this money was given to Betty on the "understanding" that Betty would use it to satisfy the gift tax liability.⁵ Betty was, however, under no legally enforceable obligation to use the funds in that fashion.

(B) The Estate Tax Return & Litigation

Willet won the actuarial bet he might have preferred to lose. He died in 1993, within three years of the gift tax payment.

In 1995, the Estate prepared an estate tax return indicating zero tax liability. The zero balance reflected: (1) the absence of any tax payment on the abovedescribed gift tax, based on the assumption that Betty made the payment; and (2) a marital trust comprising the remaining estate (after expected administration expenses), which passed to Betty and was therefore eligible for the marital deduction.

The IRS — predictably — disagreed with the Estate's tax return. The IRS claimed that, in substance if not in form, Willet paid the gift taxes so the $1,415,732 should be included in the Estate. In addition, as those funds did not pass to the marital trust but rather were used to benefit the beneficiaries of the life insurance trust, those funds, maintained the IRS, were not eligible for the marital deduction. The IRS consequently assessed a tax deficiency on the $1,415,732 and interest thereon.

The Estate — predictably — did not accept the IRS analysis. The executor remitted the requested sums but filed for a claim of abatement. After the IRS took no action on the abatement request, the executor filed for a rebate in 1999, raising several claims.

The Estate claims, first, that the gift taxes paid by Betty should not be included in the Estate. On cross-motions for summary judgment the district court denied that contention. Applying the "step transaction" doctrine, the district court determined that the transactions leading up to Betty's satisfaction of the gift tax liability should be treated, for tax purposes, as one integrated transaction. Using that approach, Willet becomes the taxpayer, as the gift tax payment traces back to Willet's gift to Betty of the precise amount of the tax. We agree with the district court that the gift tax payment is properly attributed to Willet.

The Estate also advances an alternative approach which, it argues, entitles it to a refund. The Estate notes that it actually incurred $3,592,024 in administration expenses, deductible from the gross estate under § 2053(a)(2). Because those expenses exceeded (by $1,712,024) the deduction the estate originally claimed for administration expenses ($1,880,000), the Estate argues that it was entitled to increase the administration expense deduction by $1,712,024. In a similar vein, the Estate argues that it is entitled to a deduction, under § 2053(a)(2), for the interest paid on unpaid estate taxes.

The IRS agrees that the Estate may deduct the additional administration expense and interest. It maintains, however, that some of the increased deductions require a corresponding decrease in the marital deduction. In essence, the IRS argues that some of the increased expenses were paid out of funds otherwise earmarked for the marital trust, so that any increase in those expenses decreased those funds and therefore the marital deduction.

On this...