Opinion ID: 37073
Heading Depth: 3
Heading Rank: 2

Heading: Income Tax Liability

Text: We now turn to whether the value of the Retirement Accounts should have been discounted to reflect the potential federal income tax liability to the beneficiaries upon distribution from the accounts. Before discussing the valuation method of the Retirement Accounts, it is useful to discuss the nature of those accounts and the tax treatment they are afforded by the Internal Revenue Code with respect to the decedent and his beneficiaries. The Retirement Accounts here were funded with tax-deferred compensation. In other words, the income used to purchase the assets in the Retirement Accounts has never been subject to income tax. Had the decedent’s Retirement Accounts been 10 distributed to him during his life, he would have paid a federal income tax on the distribution. See, e.g., 26 U.S.C. § 402(b)(2).4 However, the Retirement Accounts remained intact at the date of the decedent’s death. The contents of the accounts, which were not properly includible in computing the decedent’s taxable income for the taxable year ending on the date of his death or for any previous taxable year, are classified under § 691(a) of the Internal Revenue Code as “income in respect of a decedent.” 26 U.S.C. § 691(a)(1); 26 C.F.R. § 1.691(a)-1. To preserve the taxability of items of income in respect of a decedent in the hands of the beneficiaries, such items are excepted by statute from the usual step-up in basis to fair market value. 26 U.S.C. § 1014(c). Income in respect of a decedent must be included in the gross income, for the taxable year when received, of the decedent’s beneficiaries. 26 U.S.C. § 691(a)(1)(B). Thus, when the Retirement Accounts are actually distributed, the beneficiaries must pay an income tax on the proceeds. Id. Even though the federal income tax on the income used to 4 Section 402(b)(2) provides in pertinent part: (b) Taxability of beneficiary of nonexempt trust. . . . (2) Distributions. The amount actually distributed or made available to any distributee by any trust described in paragraph (1) shall be taxable to the distributee, in the taxable year in which so distributed or made available . . . . 11 purchase the assets in the Retirement Accounts was thus deferred, the accounts are still considered part of the decedent’s estate for federal estate tax purposes. 26 U.S.C. § 2039(a). As such, the Estate must pay an estate tax on the value of the Retirement Accounts. Id. To summarize, then, the Retirement Accounts are subject to an estate tax, and in addition, an income tax will be assessed against the beneficiaries of the accounts when the accounts are distributed. To compensate (at least partially) for this potentially double taxation, Congress enacted § 691(c) of the Internal Revenue Code, which grants the recipient of income in respect of a decedent an income tax deduction equal to the amount of federal estate tax attributable to that asset.5 26 U.S.C. § 691(c). Therefore, in our scenario, the decedent’s 5 Section 691(c) provides: (c) Deduction for estate tax.
(A) General rule. A person who includes an amount in gross income under subsection (a) shall be allowed, for the same taxable year, as a deduction an amount which bears the same ratio to the estate tax attributable to the net value for estate tax purposes of all the items described in subsection (a)(1) as the value for estate tax purposes of the items of gross income or portions thereof in respect of which such person included the amount in gross income (or the amount included in gross income, whichever is lower) bears to the value for estate tax purposes of all the items described in subsection (a)(1). 12 beneficiaries will be allowed a deduction in the amount of federal estate tax paid on the Retirement Accounts. Finally, the deduction is allowed in the same year the income is realized-- that is, when the Retirement Accounts are actually distributed. See 26 U.S.C. § 691(c)(1)(A). Against this backdrop, we consider the Estate’s argument and apply the valuation method specified by the Internal Revenue Code. Section 2031 provides that the value of the decedent’s gross estate is determined by including the value at the time of his death of all of his property. 26 U.S.C. § 2031(a). “The value of every item of property includible in a decedent’s gross estate . . . is its fair market value . . . .” Treas. Reg. § 20.2031-1(b) (2004); accord Cook, 349 F.3d at 854. Fair market value is defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.” Treas. Reg. § 20.2031-1(b); accord United States v. Cartwright, 411 U.S. 546, 551 (1973); Cook, 349 F.3d at 854. “The buyer and seller are hypothetical, not actual persons.” Estate of Jameson v. Commissioner, 267 F.3d 366, 370 (5th Cir. 2001). This court has stated that “[w]hen applying the willing buyer-willing seller test . . . the ‘“willing seller” is not the estate itself, but is a hypothetical seller.’” Adams v. United States, 218 F.3d 383, 386 (5th Cir. 2000) (per curiam) (quoting Estate of Bonner v. United States, 84 13 F.3d 196, 198 (5th Cir. 1996)) (alterations in original). In applying this test, the tax court has specifically refused to view the sale as one between the estate and the beneficiary. Estate of Robinson v. Commissioner, 69 T.C. 222, 225 (1977). In Estate of Robinson, the estate asset at issue was an installment note which constituted income in respect of a decedent. The estate argued that in order to determine the fair market value of the note for purposes of the estate tax, one must take into consideration the income tax payable by the beneficiaries as the installments mature, rather than valuing the note under the willing buyer-willing seller test. Id. The tax court disagreed, holding that Treas. Reg. § 20.2031-1(b) explicitly provides that property, such as the note at issue, is to be valued, for estate tax purposes, under an objective approach applying the willing buyer-willing seller test. There is no support in the law or regulations for [the estate’s] approach which is designed to arrive at the value of the transfer as between the individual decedent and his estate or beneficiaries. Id. In its brief, the Estate argues that the fair market value of the Retirement Accounts should reflect its “inherent income tax liability.” Specifically, it asserts that the value of the assets in the Retirement Accounts should have been discounted to reflect the federal income tax liability to the beneficiaries upon distribution from the accounts. The Estate fails to acknowledge that the willing buyer-willing seller test is an 14 objective one. Thus, the hypothetical parties are not the Estate and the beneficiaries of the Retirement Accounts. Accordingly, we do not consider that the particular beneficiaries in this case are receiving income in respect of a decedent and will eventually pay tax on the distributions from the Retirement Accounts because doing so would alter the test from a hypothetical sale into an actual one. Applying the test appropriately then entails looking at what a hypothetical buyer would pay for the assets in the Retirement Accounts.6 The Retirement Accounts consist of stocks and bonds. A hypothetical buyer would pay the value of the securities as reflected by the applicable securities exchange prices. A hypothetical seller would likewise sell the securities for that amount. Correctly applying the willing buyer-willing seller test demonstrates that a hypothetical buyer would not consider the income tax liability to a beneficiary on the income in respect of a decedent since he is not the beneficiary and thus would not be paying the income tax. The Estate’s position is further eroded when one considers what income tax rate should be employed under the Estate’s argument. In this case, the Estate’s position on the applicable rate is, at best, muddled. In the Estate’s refund claim, the Estate asserted that the applicable tax rate would be thirty 6 As the parties recognize, the Retirement Accounts, by their terms, cannot be sold. For this reason, the debate here is over the value of the constituent assets. 15 percent, and it was specifically on the basis of this rate that the claimed discount was predicated. The valuation expert’s opinion included in the Estate’s summary judgment evidence notes that when the Retirement Accounts are distributed, the respective payors will be obligated to withhold twenty percent of the amount of any distribution for application against any income tax liability of the beneficiary. The opinion goes on to state that the beneficiary’s income tax liability could exceed the twenty percent withheld “in almost all cases.” The valuation opinion does not, however, settle on a specific tax rate to be used for the purpose of valuing the Retirement Accounts. At oral argument, in response to a question about how the thirty-percent discount in the refund claim was arrived at, counsel for the Estate stated (inconsistently with the Estate’s refund claim) that the thirty-percent discount took into account all the factors identified in the expert’s opinion, including the lack of marketability and the “inherent income tax.” The muddle in the record and at oral argument about the tax rate stems from the fact the Internal Revenue Code is devoid of a provision that would flesh out the Estate’s position, putting the Estate in the position of having to make up a theory to support the amount of its claimed discount. The theory is predicated on the fact that a beneficiary will have to pay income tax on a distribution from the Retirement Accounts, but the beneficiary’s actual tax rate for some future year when the distribution is made is simply 16 unknown. The Estate’s argument is exactly the kind of beneficiary-specific inquiry, with the added feature of speculation on the future, that the hypothetical willing buyerwilling seller test precludes. The Estate, however, contends there is a recent trend, as evidenced by several cases, of considering potential tax liability in valuation.7 See Dunn v. Commissioner, 301 F.3d 339 (5th Cir. 2002); Estate of Jameson, 267 F.3d at 366; Eisenberg v. Commissioner, 155 F.3d 50 (2d Cir. 1998); Estate of Davis v. Commissioner, 110 T.C. 530 (1998). In those cases, the estate asset at issue was stock in a closely-held corporation, and the court was faced with the question whether the capital gains tax that would be payable upon the sale of assets held by the corporation would factor into the fair market value of the corporation’s stock. See Dunn, 301 F.3d at 339; Estate of Jameson, 267 F.3d at 366; Eisenberg, 155 F.3d at 50; Estate of Davis, 110 T.C. at 530. As the government urges, these cases are distinguishable. First, this case involves a different sort of asset–-i.e., Retirement Accounts containing marketable stocks and bonds. Thus, the rationale in those cases, that a hypothetical 7 This so-called “trend,” as discussed in the same cases cited by the Estate, is attributable to the abrogation, by the Tax Reform Act of 1986, of the General Utilities doctrine, General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), dealing with corporate liquidations. See Dunn, 301 F.3d at 339; Estate of Jameson, 267 F.3d at 366; Eisenberg, 155 F.3d at 50; Estate of Davis, 110 T.C. 530. 17 buyer would discount the price of stock in a closely-held corporation to reflect the capital gains taxes that would be payable by the buyer in the event of a subsequent liquidation of the corporation, is wholly inapplicable here. Second, while the stock considered in the above cases would have built-in capital gains even in the hands of a hypothetical buyer, the Retirement Accounts at issue here would not constitute income in respect of a decedent in the hands of a hypothetical buyer. Income in respect of a decedent can only be recognized by: (1) the estate; (2) the person who acquires the right to receive the income by reason of the decedent’s death; or (3) the person who acquires the right to receive the income by bequest, devise, or inheritance. 26 U.S.C. § 691(a)(1). Thus, a hypothetical buyer could not buy income in respect of a decedent, and there would be no income tax imposed on a hypothetical buyer upon the liquidation of the accounts. Third, as we have seen, Congress has provided relief, in § 691(c), from the income tax that would be imposed on the decedent’s beneficiaries in the form of a deduction for the estate taxes paid with respect to the inclusion in the gross estate of the Retirement Accounts. In contrast, in the case of closely-held corporate stock, the capital-gains tax potential survives the transfer to an unrelated third party, and Congress has not granted any relief from the secondary tax. We therefore conclude that the district court did not err in refusing to consider the potential federal income tax liability 18 to the beneficiaries when valuing the Retirement Accounts. As the district court stated, Congress has addressed the Estate’s concerns in § 691(c). The courts have no business improving on Congress’s efforts.