Estate of Armstrong v. USA.

• Decision Date: 30 October 2001
• Docket Number: No. 01-1305,01-1305
• Citation: 277 F.3d 490
• Parties: (4th Cir. 2002) ESTATE OF FRANK ARMSTRONG, JR., Frank Armstrong, III, Executor; FRANK ARMSTRONG, JR., Trust For Benefit of Frank Armstrong, Jr., Frank Armstrong, III, Trustee, Plaintiffs-Appellants, v. UNITED STATES OF AMERICA, Defendant-Appellee. Argued:
• Court: U.S. Court of Appeals — Fourth Circuit

Page 490

277 F.3d 490 (4th Cir. 2002)

ESTATE OF FRANK ARMSTRONG, JR., Frank Armstrong, III, Executor; FRANK ARMSTRONG, JR., Trust For Benefit of Frank Armstrong, Jr., Frank Armstrong, III, Trustee, Plaintiffs-Appellants, v. UNITED STATES OF AMERICA, Defendant-Appellee.

No. 01-1305

UNITED STATES COURT OF APPEALS FOR THE FOURTH CIRCUIT

Argued: October 30, 2001

Decided: January 15, 2002

Appeal from the United States District Court for the Western District of Virginia, at Harrisonburg. James H. Michael, Jr., Senior District Judge. (CA-98-101-5) ARGUED: Stephen L. Pettler, Jr., HARRISON & JOHNSTON, Winchester, Virginia, for Appellants. Joan Iris Oppenheimer, Tax Division, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee. ON BRIEF: Aubrey J. Owen, OWEN & TRUBAN, P.L.C., Winchester, Virginia, for Appellants. Claire Fallon, Acting Assistant Attorney General, Richard Farber, Ruth E. Plagenhoef, United States Attorney, Tax Division, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

Before WILKINSON, Chief Judge, MOTZ, Circuit Judge, and Malcom J. HOWARD, United States District Judge for the Eastern District of North Carolina, sitting by designation.

Affirmed by published opinion. Judge Motz wrote the opinion, in which Chief Judge Wilkinson and Judge Howard joined.

OPINION

DIANA GRIBBON MOTZ, Circuit Judge:

At the age of 91, Frank Armstrong, Jr. gave very substantial gifts of stock to his four children and, primarily through a trust he created, paid millions of dollars in gift taxes on those gifts. Armstrong died less than three years later, triggering estate taxes on those gift taxes. In addition, the IRS assessed additional gift taxes on the grounds that Armstrong undervalued the stock when the original gift taxes were paid. Armstrong's estate and the trust bring this action seeking a refund of both the original and the additional gift taxes. They maintain that the donee children's purported obligation to pay additional gift taxes and potential liability for estate taxes on gift taxes markedly reduced the value of the gifts and thus should reduce the gift taxes attributable to them pursuant to the "net gift" doctrine. We agree with the district court that, given the speculative and illusory nature of the donees' obligation to pay gift and estate taxes, the net gift doctrine does not apply here. Accordingly, we affirm.

I.

The parties stipulated to all relevant facts, and so"[t]he material facts in this matter are undisputed." Brief of Appellants at 9.

A.

In 1991, Frank Armstrong, Jr., then 91 years old, and his four children agreed that Armstrong would carry out his estate plan through inter vivos transfers of his stock in National Fruit Products, Inc., a privately held corporation in which Armstrong owned the controlling interest. The children welcomed this approach because of their concern that Armstrong "might take further actions which would be detrimental to the value of National Fruit shares as a family business" and to them "as heirs of the stock." The events giving rise to this concern included Armstrong's recent transfer of real estate to two young women with whom Armstrong had kept company and his naming of a new executor unfamiliar to the children.

In structuring the gifts of stock, Armstrong, the children, and National Fruit extensively consulted with counsel and repeatedly negotiated with each other. They obtained an appraisal of the value of Armstrong's National Fruit stock and "numerous projections of the tax consequences" of "various scenarios." On the advice of counsel, Armstrong and the children expressly declined to adopt an arrangement requiring the children to pay all gift taxes on the gross gifts they received -that is, a traditional net gift arrangement. The children further declined, also on advice of counsel, to enter into a written agreement to pay the estate taxes on the gift taxes that would be triggered should Armstrong die within three years of making the gifts. Indeed, throughout these consultations and negotiations, the children made clear that they wanted the transfers structured to reduce their gift and estate tax liabilities and to "minimize" their own "direct cash outlay." Armstrong, for his part, would agree to the stock transfers only if, inter alia, he received continuing income comparable to his prior dividend payments and was personally exonerated from the expenses and taxes resulting from the stock transfers.

Through the agreed-upon stock transfers, Armstrong was completely divested of all his National Fruit stock, and control of the corporation was shifted to the children. The stock transfers were carried out over two tax years as follows. In December 1991 (the "1991 transaction"), Armstrong conveyed 5,725 shares of his National Fruit common stock to each of his four children and 100 shares to each of his eleven grandchildren. In addition, National Fruit redeemed all of Armstrong's preferred stock for approximately $1,534,150 in cash, plus a private annuity payable to Armstrong. The bulk of the cash from the preferred stock redemption was paid to charitable organizations in donations, although $219,150 was later used to fund the Trust.

In January 1992 (the "1992 transaction"), Armstrong transferred more than 12,000 additional shares of his National Fruit common stock to each of his children. Armstrong also again transferred 100 unredeemed shares to his grandchildren, this time apportioned from the otherwise equal allotments of their respective parents, and transferred approximately 5,000 shares of his common stock to two trusts, a generation-skipping trust and an employee trust, which are not relevant to the current action. National Fruit redeemed Armstrong's remaining common stock, as represented by a promissory note given to Armstrong in the amount of $6,065,300. Then, using the $219,150 from the previous redemption of preferred shares, Armstrong created a grantor trust and assigned the promissory note to that Trust. Under the trust agreement, an irrevocable trust was created naming Armstrong as "the beneficiary." The trust agreement provides for quarterly income payments to Armstrong and that the Trustee "shall pay" the gift and income tax owed by Armstrong in connection with the 1991 and 1992 transactions.

Also as part of the 1991 and 1992 transactions, the children entered into a transferee liability agreement. That agreement provides that the children would pay "the additional gift taxes . . . arising by reason of any proposed adjustment to the amount of the 1991 and 1992 gifts." Thus, this agreement appeared to impose on the children the obligation to pay any additional gift taxes in the event the Internal Revenue Service (IRS) subsequently determined that Armstrong had undervalued the gifted stock on his tax returns. However, an attorney who advised Armstrong and his children "regarding the gifts of stock" submitted an affidavit on behalf of the Estate and the Trust in which he stated that the parties agreed that Armstrong would "use a grantor trust to assure payment of taxes . . . in connection with a proper final determination thereof" and the donees would only be "secondarily liable" for these taxes. This same attorney concluded that "[t]he donor . . . and the donees intended" that the arrangement ultimately agreed upon "would protect the donees . . . from having to pay taxes."

In his gift tax returns for 1991 and 1992, Armstrong valued the transferred stock at $100 per share and reported gift tax liability of $1,229,483 in 1991 and $3,027,090 in 1992. The Trust and Armstrong himself paid all of these taxes; the Trust paid the lion's share, a total of more than $4.2 million for the two years, while Armstrong individually paid just over $40,000. The children paid no gift taxes.

On July 29, 1993, less than three years after the 1991 and 1992 transactions, Armstrong died. He had suffered recurring pulmonary problems prior to the 1991 and 1992 transactions, although the parties stipulated that he did not suffer from any life-threatening conditions at the time of the stock transfers.

Following Armstrong's death, the IRS valued the gifted stock, as of the date of the transfers, at $109 per share. This change in valuation resulted in increased gift tax liability of approximately $118,800 for 1991 and $304,910 for 1992. The children paid none of the additional gift taxes; rather, once again the Trust paid all gift taxes, with interest.

In computing the value of Armstrong's estate, the executor did not include in the estate assets the gift taxes of over $4 million that Armstrong and the Trust had paid on the stock gifts during the three years prior to his death. The IRS determined that the Internal Revenue Code required inclusion of those gift taxes in the estate and assessed an estate tax deficiency of some $2.35 million. Since the stock transfers rendered the estate without assets to pay this deficiency, the IRS assessed each donee child with liability for the estate tax deficiency to the extent of the value of the stock transferred to each.¹

B.

On April 15, 1996, Frank Armstrong, III, Armstrong's eldest son and the CEO of National Fruit, on behalf of the Estate as its Executor and the Trust as its Trustee, filed claims for refund of all the gift taxes paid in connection with the 1991 and 1992 transactions. The Estate sought a refund of the original gift taxes paid on the stock transferred in the amount of some $1,348,283 with respect to the 1991 transfers and some $3,332,000 with respect to the 1992 transfers; the Trust sought a refund of the additional gift taxes in the amount of some $118,800 with respect to 1991 transfers and some $304,910 with respect to the 1992 transfers. An identical premise drove the refund claims: the obligation of Armstrong's children to pay additional gift taxes and estate taxes as a condition of the gifts had substantially reduced the value of the gifts and, accordingly, the...