Valuation of IRAs for estate tax purposes.

In Est. of Kahn, 125 TC No. 11 (2005), the Tax Court considered for the first time whether IRAs could be discounted for estate tax purposes. It determined that an IRA could not be discounted; rather, the underlying assets in the account must be valued on the date of the decedent's death.

Background

Under Sec. 408(e), an IRA is a tax-exempt vehicle. However, Sec. 408(d) provides that distributions to an account owner (or, in the event of the owner's death, to the IRA beneficiaries) are subject to the Sec. 72 rules for income taxation of distributions from an annuity. To the extent that amounts remain in an IRA on the account owner's death, the balance is includible in his or her estate for estate tax purposes under Sec. 2039. The owner's death, however, does not extinguish the income tax liability associated with IRA distributions; the distribution is income in respect of a decedent (IRD) for income tax purposes. Under Sec. 691, a recipient of an IRA distribution has to include it in gross income in the same manner as the account owner (who would have been required to include it in gross income).

Facts

In Kahn, the decedent died owning two IRAs that had not been distributed to her before her death. Both IRA agreements provided that the accounts were nontransferable, but the underlying assets (securities) could be sold and others purchased at her direction. The decedent's estate tax return listed the fair market value (FMV) of the IRAs at less than the FMV of the underlying securities. The IRS position was that the IRAs' FMVs for estate tax purposes were the values of the underlying marketable securities.

The parties agreed the IRAs were includible in the decedent's estate for estate tax purposes, and that use of the Regs. Sec. 20.2031-1(b) "willing buyer-willing seller test" was proper to determine an asset's FMV for estate tax purposes. Under this test, the FMV of an asset is the price at which it would "change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having knowledge of relevant facts." The courts have determined that the test is objective and relies on hypothetical parties rather than specific individuals; see, e.g., Est. of Bright, 658 F2d 999 (5th Cir. 1981). However, the parties disagreed on which assets should be subjected to the test.

Estate's Argument

The estate contended that the IRAs, not their underlying assets, were subject to valuation for estate tax purposes. Further, the willing buyer-willing seller test mandated discounting the IRAs for (1) the income tax liability associated with their distributions and (2) their lack of marketability. The estate noted that, pursuant to the IRA agreements, the IRAs were nontransferable and, thus, unmarketable. As such, the only way the account owner could create an asset a willing seller could sell and a willing buyer would buy was to distribute the IRAs' underlying assets and pay the resulting income tax liability. Thus, the income tax liability was necessary in rendering the assets marketable, a cost which had to be taken into account in valuing the IRAs for estate tax purposes.

In support of its arguments, the estate cited three lines of cases in which the courts allowed a discount for estate tax purposes similar to the discount it was claiming. In the first case, a discount was permitted due to the consideration of a future tax detriment or benefit to the estate's assets (e.g., a discount for the built-in gain tax for stock in a closely held corporation that held appreciated assets); see, e.g., Est. of Smith, 198 F3d 515 (5th Cir. 1999), rev'g 108 TC 412 (1997). Second, marketability discounts were allowed for assets that were either unmarketable or significantly restricted as to marketability (e.g., stock in a nonpublic company); see, e.g., Est. of Davis, 110 TC 530 (1998).Third, some courts permitted a discount due to the cost of making an asset marketable (e.g., the costs associated with rezoning or decontamination of real property); see, e.g., Est. of Necastro, TC Memo 1994-352.

Tax Court's Analysis

The court addressed and rejected each argument. It noted that all of the estate's contentions failed for a common reason--a willing buyer would not consider the income tax liability associated with the IRAs in purchasing their assets, because (1) IRAs are not transferable and (2) the income tax liability on distributions cannot be transferred to a willing buyer.

For estate tax purposes, the IRAs were not transferable. Thus, they were unmarketable, and could not be considered assets subject to the willing buyer-willing seller test for estate tax valuation purposes. However, the underlying marketable securities could be subjected to this test. According to the court, the marketable securities, once distributed from the IRAs, did not carry a tax burden a hypothetical willing buyer would assume if he or she were to purchase them. Thus, the tax burden could not be considered in valuing the marketable securities for estate tax purposes.

In further support of its determination, the Tax Court cited Est. of Smith, 300 FSupp2d 474 (SD TX, 2004), aff'd, 391 F3d 621 (5th Cir. 2004). In Smith, the Fifth Circuit was asked whether qualified retirement plans (i.e., IRS) to the extent not distributed to the account owner before death) held by a decedent at death could be discounted for the associated income tax liability. The Fifth Circuit held the proper valuation of the plans to be the FMV of the marketable securities held (as determined by reference to applicable securities rates and the date of the decedent's death), but did not include a discount for associated income tax liabilities.

Central to the Fifth Circuit's reasoning in Smith, and cited with approval by the Tax Court in Kahn, was the determination that a beneficiary's responsibility for the income tax liability on IRD is not a consideration of hypothetical willing buyers and sellers. It noted that the estate failed to recognize that the willing buyer-willing seller test was an objective one; thus, the beneficiaries of the qualified retirement plans were not hypothetical willing buyers, and the estate was not a hypothetical willing seller.

Citing Smith, the Tax Court reasoned that the IRAs' income tax liability and/or lack of marketability must be borne by the seller. The IRAs could not legally be sold and, thus, their inherent income tax liability could not be passed to a hypothetical buyer. The court held that, in applying the willing buyer-willing seller test to the IRAs, a hypothetical willing buyer would not consider the income tax liability, because such buyer is not an IRA beneficiary and, thus, would not be responsible for it. The court further determined that a hypothetical willing seller would not consider the income tax liability, because, in determining price, the willing seller would not accept a price reduction for an income tax liability that would not survive the transfer of the asset.

Conclusion

The Tax Court concluded that the IRAs' FMVs could not be discounted, because the IRAs were not the proper assets to value for estate tax purposes. The accounts were not transferable and, thus, not capable of being valued under the willing buyer-willing seller test. However, the underlying assets were capable of valuation because, unlike the IRAs, they were marketable. The income tax liability associated with distributions from the IRAs could not be passed to a willing buyer of the assets. Thus, a hypothetical willing buyer and willing seller would not take into consideration the income tax liability associated with the asset distribution from an IRA, in determining the purchase price of the IRA's assets.

The Tax Court's reasoning in Kahn highlights that in determining the value of an asset for estate tax purposes, FMV is not necessarily the asset's value in the beneficiary's hands. Rather, FMV for estate tax purposes is the value established under the objective willing buyer-willing seller test. In most cases, there will be no real distinction between the value of an asset for estate tax purposes and its value in a beneficiary's hands. A distinction, however, will occur when an asset is subject to a burden unique to the beneficiary, which cannot be passed to the buyer. This is because the "hypothetical" willing buyer-willing seller test does not take into account the burden of an asset unique to a seller or the benefit of an asset unique to a buyer. The Tax Court's holding in Kahn, however, should not be interpreted to prevent the applicability of discounts to an IRA's underlying assets.

FROM JUSTIN RANSOME, J.D., MBA, CPA, WASHINGTON, DC

Editor: Stefan Gottschalk, J.D., LL.M., CPA Senior Manager Grant Thornton LLP Washington, DC