PUBLISHED

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

ESTATE OF FRANK ARMSTRONG, JR., 

Frank Armstrong, III, Executor;

FRANK ARMSTRONG, JR., Trust For

Benefit of Frank Armstrong, Jr.,

Frank Armstrong, III, Trustee,  No. 01-1305 Plaintiffs-Appellants,

v.

UNITED STATES OF AMERICA,

Defendant-Appellee. 

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: October 30, 2001

Decided: January 15, 2002

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. 

COUNSEL

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. 

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

2 ESTATE OF ARMSTRONG v. UNITED STATES
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. 

ESTATE OF ARMSTRONG v. UNITED STATES 3
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,

4 ESTATE OF ARMSTRONG v. UNITED STATES
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

1The Estate and children challenged these determinations in tax court.

The tax court upheld the donee children’s transferee liability. See Armstrong v. Comm’r, 114 T.C. 94, 96 n.4, 102 (2000). This transferee liability attached by law pursuant to 26 U.S.C. § 6324(a)(2), independent of

any liability the children assumed pursuant to the transferee liability

agreement. Id. at 102. 

ESTATE OF ARMSTRONG v. UNITED STATES 5
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 resulting gift

taxes. The IRS disallowed the claims. 

The Estate and the Trust then filed suit in the district court for

refund of all gift taxes. In addition to arguing that the children’s

responsibility for additional gift taxes and estate taxes reduced the

value of the transferred stock, the Estate and the Trust also alleged

that the transfers did not constitute valid gifts and that the encumbrances on the transferred stock greatly diminished the marketability

of the stock, rendering it of only nominal value. The Estate and the

Trust cast their claims under a variety of legal theories. For example,

they contended that the children’s obligation to pay additional gift and

estate taxes created liens or transferee liability at law, the children’s

express or implied assumption of Armstrong’s obligations reduced the

stock’s value, and the stock transfers were incomplete. The taxpayers

even alleged, remarkably, that Armstrong had retained the power to

revoke the transfers "by refusing to accept heroic measures and procedures for prolonging his life or by otherwise acting, or refusing to act,

in a manner calculated to eliminate his chances of surviving for three

years" after the stock transfers. 

A magistrate judge recommended that the district court either dismiss or grant summary judgment to the Government on each of the

taxpayers’ claims. After the Estate and Trust filed timely objections

to this recommendation, the district court conducted a careful de novo

review. The court first determined to dismiss two of the taxpayers’

claims for lack of subject matter jurisdiction because the claims had

not been presented in the administrative proceeding. See 26 U.S.C.A.

7422(a) (West 1989); 26 C.F.R. § 301.6402-2(b)(1) (2001) (requiring

the basis for all tax refund suits in federal court to be timely presented

first to the IRS). Specifically, the court dismissed the argument that

the tax consequences of the gifts had eliminated the market for the

stock, as well as the taxpayers’ efforts to deny that the gifts were ever

6 ESTATE OF ARMSTRONG v. UNITED STATES
made, declaring that the taxpayers’ "own unwavering reference to the

transfers as gifts through the refund claim process" and their "failure

to assert in the administrative claim the ground that there was no valid

gift" or that the stock had no value was fatal to their ability to make

such claims in the current action. 

The district court then recognized that the validity of all of the taxpayers’ remaining contentions rested on determination of whether the

donee children’s asserted obligations to pay additional gift and estate

taxes reduced the value of the National Fruit stock at the time of the

transfers. The court concluded that the donees’ asserted obligations

did not reduce the value of the transferred stock, and that the net gift

rules did not apply, and therefore granted summary judgment on the

remaining claims to the Government. The Estate and the Trust appeal.

We review the district court’s grant of summary judgment de novo.

Miller v. AT&T Corp., 250 F.3d 820, 830 (4th Cir. 2001). 

II.

Resolution of this appeal requires that we determine whether the

donee children’s asserted obligation to pay additional gift taxes and

estate taxes associated with the 1991 and 1992 transactions reduced

the value of Armstrong’s gifts to them at the time of the stock transfers. 

The Internal Revenue Code generally imposes a gift tax on property, excluding certain minimal amounts, see 26 U.S.C.A. § 2503(b)

(West 1989), that an individual transfers as a gift during any tax year.

26 U.S.C.A. § 2501(a)(1) (West 1989). When property is given, the

tax is based on its value at the time of the transfer. 26 U.S.C.A.

§ 2512(a) (West 1989). By statute, the donor is responsible for payment of the gift tax, 26 U.S.C.A. § 2502(c) (West 1989), but a donee

may contractually assume liability for the donor’s gift tax obligations.

See, e.g., Diedrich v. Comm’r, 457 U.S. 191 (1982); Rev. Rul. 75-72,

1975-1 C.B. 310 (1975); Rev. Rul. 80-111, 1980-1 C.B. 208 (1980).

When a donee agrees to pay the donor’s gift tax obligations as a

condition of receiving the gift, the donee need only pay gift taxes on

the net gift. Rev. Rul. 75-72. The net gift is determined by deducting

the amount of the gift tax obligation from the value of the transferred

ESTATE OF ARMSTRONG v. UNITED STATES 7
property. Id. The rationale for the net gift doctrine is that a donor who

has required the donees to pay gift taxes on transferred property "did

not intend that the amount of the value of the property necessary for

the gift tax liability would be a gift." Harrison v. Comm’r, 17 T.C.

1350, 1357 (1952). 

Because the value of property at the time of transfer is the basis for

calculating the gift tax, a donee seeking the benefit of net gift principles must demonstrate that payment of the gift taxes was a condition

on the gift at the time of transfer. Rev. Rul. 75-72. Any obligation of

the donee to pay gift taxes that is speculative or illusory evidences

that the obligation was not a true condition on the gift at the time of

the transfer, and so did not diminish the value of the transferred property, in which case the entire value of the property is a gift subject to

gift taxes. See Robinette v. Helvering, 318 U.S. 184, 188 (1943)

(holding that net gift principles do not apply to "contingent" liability);

Rev. Rul. 75-72 (providing that net gift principles require "the resulting [gift] tax . . . actually be paid by the donee or from the subject

property"). 

A.

The Estate and the Trust initially argue that net gift principles

apply to reduce the value of the transferred stock by the amount of

additional gift taxes paid by the Trust after Armstrong’s death. The

taxpayers maintain that the transferee liability agreement required the

children to pay these additional gift taxes and this obligation created

a "retained interest in the donor and therefore a ‘net gift.’" 

The first problem with this contention is that the children’s obligation to pay the additional gift taxes was both contingent and highly

speculative. When a condition on a gift is contingent, the Supreme

Court has held that the value of the gift is not to be reduced for gift

tax purposes. See Robinette, 318 U.S. at 188 (1943) (refusing to allow

taxpayer to reduce the tax value of a gift by the value of a "reversionary interest" because the value of the reversion was "contingent"). 

In the typical arrangement in which "net gift" principles apply —

an arrangement that Armstrong and his children specifically rejected

— the donor transfers property to the donee on the condition that the

8 ESTATE OF ARMSTRONG v. UNITED STATES
donee pay all resulting gift taxes. See Rev. Rul. 75-72. In such a situation, there is no dispute that the donee is liable for the gift tax, even

if the total amount of the tax is not determined until a later juncture.

See, e.g., Harrison, 17 T.C. at 1353-54, 1356 (recognizing donee’s

ability to deduct additional gift taxes due under statement of deficiency in calculating net gift). Here, however, Armstrong’s children

only had an obligation to pay additional gift taxes in the event of an

undervaluation of the transferred property, an event all parties sought

to avoid by careful valuation of the stock and adequate funding of the

Trust. In fact, the children fully expected and intended, according to

the counsel who advised them with respect to the 1991 and 1992

transactions, that they were protected "from having to pay taxes and

expenses incurred as a result" of the transactions. Because the donees’

obligation to pay additional gift taxes was premised solely on undervaluation, a probability no one expected to arise, the obligation was

contingent and too speculative to justify application of net gift principles.

Moreover, even were we to hold that the donee children’s obligation to pay the additional gift taxes was not speculative, the Estate and

the Trust would not be entitled to a refund because of gift taxes paid

based on net gift principles. This is so because in addition to being

contingent, the children’s obligation to pay the additional gift taxes

was illusory. 

In fact, the Trust — the same entity that paid the initial gift taxes

— paid the additional gift taxes. Furthermore, as the Estate and Trust

concede, the Trust paid the additional gift taxes "pursuant to the terms

of the Grantor Trust," which Armstrong established coincident with

the stock transfers. That the terms of the grantor trust agreement provided for the payment of the additional gift taxes, and the Trust in fact

paid them, renders unpersuasive the taxpayers’ contention that the

transferee liability agreement created a true obligation on the children

to pay the additional gift taxes. 

The taxpayers would have us credit the terms of the transferee liability agreement (imposing liability for additional gift taxes on the

donee children), ignoring not only the contrary provision of the

grantor trust agreement (imposing this same liability on the Trust),

but also the reality that the Trust in fact paid the additional gift taxes

ESTATE OF ARMSTRONG v. UNITED STATES 9
and the donee children have paid no gift taxes. This we will not do.

See Seward’s Estate v. Comm’r, 164 F.2d 434, 436-37 (4th Cir. 1947)

("Taxation . . . is a practical matter and in this field the courts will

not be bound by legal refinements in the literal interpretation of contracts when there is evidence that they do not express the real intent

of the parties. . . . [T]he practical interpretation placed upon a contract

by the subsequent acts of the parties themselves may be taken into

consideration."). As a practical matter, the children obtained the full

value of the stock transfers because their father established a trust

charged with paying the gift taxes on these transfers and that Trust in

fact paid the gift taxes, thus belying the suggestion that the children

obtained only a net gift. 

The taxpayers attempt to avoid this conclusion by arguing that the

Trust’s payment of the gift taxes constituted payment by the children

because the Trust was established by the children and for their benefit.2

The undisputed facts belie this characterization. First, the very title of

the Trust — the "Frank Armstrong, Jr. Trust for the Benefit of Frank

Armstrong, Jr." — demonstrates that it was created for the benefit of

Armstrong, not his children. Second, the written terms of the trust

agreement entirely accord with its title — Armstrong is the named

donor and sole beneficiary during his life. Third, Armstrong funded

the Trust with his own property, which did not originate with or even

pass through the hands of the children. Fourth, except for the $40,000

in gift taxes paid by Armstrong himself, the Trust paid all of the gift

taxes attributable to the gifts made by Armstrong, as donor. Fifth, the

donee children specifically consented to "go[ing] forward with the

transaction[s] on Armstrong’s terms" after weighing the potential

benefits against what they knew were substantial risks. In sum, tax

2

In support of this argument, the Trust and the Estate also contend that

the 1991 and 1992 transactions, including the establishment of the Trust,

were carried out in lieu of inheritances the children would have received

under Armstrong’s will. This contention does not assist them in any way.

"[W]hile a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his

choice, whether contemplated or not . . . and may not enjoy the benefit

of some other route he might have chosen to follow but did not."

Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149

(1974) (citations omitted). 

10 ESTATE OF ARMSTRONG v. UNITED STATES
payments by the Trust were not in any way actually payments by the

children. 

We conclude that the children’s obligation to pay additional gift

taxes was both speculative and illusory and did not reduce the value

of the stock transferred to them. 

B.

As the second basis for their claim that the transferred stock was

worth less than $109 a share at the time of the transfers, the Trust and

Estate make the corollary argument that net gift principles should

reduce the value of the gifts by the amount of estate taxes the children

are obligated to pay on the gift taxes. 

The Estate was assessed estate taxes on the gift taxes paid in connection with the 1991 and 1992 transactions because Armstrong died

within three years of making the gifts. See 26 U.S.C.A. § 2035(c)

(West 1989). The Internal Revenue Code’s "gross-up" rule requires

that the taxable estate include the value of gift taxes paid on gifts

made within this three-year period. Id. Where, as here, an estate is

insolvent or otherwise unable to pay the estate taxes on prior gift

taxes, the Code imposes personal liability for the estate tax on the

donees of the gifted property in the amount of the value of the gift

received. 26 U.S.C.A. § 6324(a)(2), (b) (West 1989). The taxpayers

contend that net gift principles should reduce the stock’s value by the

amount of estate taxes attributable to the gift taxes that the children

may be called upon to pay because the children entered the transactions knowing that Armstrong "retained insufficient assets with which

to pay such estate taxes and by implication from the circumstances

surrounding the gifts, [Armstrong] attached payment of such estate

taxes out of the transferred property as a condition of the transfer."

In Murray v. United States, 687 F.2d 386 (Ct. Cl. 1982), the court

considered and rejected a similar contention. The Murray court reasoned that although the donees were obligated to pay the donor’s

estate tax liability, "which could reduce the value of the gifts . . . the

assumed obligation was not itself susceptible to valuation at the date

of the gifts because the economic burden of paying this tax was then

unknown." Id. at 394. Relying on facts for all relevant purposes idenESTATE OF ARMSTRONG v. UNITED STATES 11
tical to those at hand — that the value of the challenged item would

not have been included in the estate if the donor had lived beyond

three years from the date of the gift and that the value of the estate

could have diminished over time — the court concluded that the

potential estate tax liability was too "highly conjectural" to justify a

reduction in the value of the gift. Id.

We find the Murray reasoning persuasive and adopt it here to conclude that the children’s estate tax liability was too speculative to

reduce the value of the gifts at the time of the 1991 and 1992 transactions. Had Armstrong lived a short time longer than he did, none of

the gift taxes would have been included in the value of his taxable

estate. Indeed, over time, the value of the estate might not have

reached the threshold at which estate taxes are imposed, particularly

since the 1991 and 1992 transactions divested Armstrong of substantial property.3

 Moreover, there is no evidence that the children agreed

to pay the resulting estate taxes — in the event there were any — as

a condition of the stock transfers. Rather, the evidence instead shows

that they intended to be protected from any tax liability stemming

from the transfers. On the advice of counsel, the children refrained

from entering any written agreement to assume liability for estate

taxes, and any liability they do have arises only by law because of the

estate’s insolvency. The litigation attempts of the Estate and the Trust

to quantify through expert calculations the value of potential estate

taxes at the time of the transfers is irrelevant. What is relevant is that

the children’s obligation to pay any estate taxes was then "highly conjectural," Murray, 687 F.2d at 394, and so provides no ground for

applying net gift principles. 

III.

Because we conclude that net gift principles do not apply to reduce

the value of the transferred stock by the amount of additional gift

3The Estate and the Trust attempt to create a ground for reversal by

challenging the district court’s failure to find, under state law, that Armstrong "relinquished dominion and control so as to result on [sic] a gift."

Given the repeated assertions of the Estate and the Trust that Armstrong

"divested himself of all stock" through the 1991 and 1992 transactions,

the district court did not err. 

12 ESTATE OF ARMSTRONG v. UNITED STATES
taxes or the estate taxes attributable to the gifts, the Estate and the

Trust are not entitled to a refund of the gift taxes paid. Accordingly,

the judgment of the district court is 

AFFIRMED.

ESTATE OF ARMSTRONG v. UNITED STATES 13