September 26, 2006

Estate Tax Valuation vs. Income Tax Valuation

Houston Tax Attorney Blog

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The question in Janis v. Commissioner is whether a taxpayer can claim that property has a low value for estate tax purposes and then turn around and claim that the property has a high value for income tax purposes. The Ninth Circuit said “no,” but the answer could have been different under slightly different facts.

Conrad and Maria Janis inherited a gallery of artwork from Conrad’s father. The artwork consisted of over 500 pieces of art by famous artists, such as Piet Mondrian, Jean Arp, and Grandma Moses. Several years prior to his demise Conrad’s father had transferred the gallery of artwork to a trust for the benefit of himself and his two sons – one of whom is Conrad. The father and the two sons were named as the trustee and the sons were named as the executors of their father’s last will and testament.

After the father’s demise, Conrad and his brother, as executors and trustees of the trust, hired Sotheby’s to value the art collection. Sotheby’s valued the collection without applying any discounts. Conrad filed fiduciary trust tax returns listing the artwork at a discounted value of $12 million. This discounted value caused the art gallery to report a net operating loss each year, minimizing the amount of taxes it owed.

The IRS Art Advisory Panel determined that the undiscounted value of the collection was $36 million and the discounted value was $14 million.

Conrad, as co-executor and trustee, consented to the IRS’s adjustment and to its discounted valuation of the estate’s artwork. Conrad signed a Form 890 Waiver of Restrictions on Assessment and Collection of Deficiency and Acceptance of Overassessment. The IRS time period for assessing the estate tax return had already expired before this time.

Immediately after signing the Form 890 Conrad filed amended fiduciary income tax returns for the trust claiming the undiscounted value of $36 million for the artwork. This increased valuation created an even larger net operating loss for the gallery.

The trust was terminated shortly thereafter and its assets were distributed to a partnership created by Conrad and his brother. The net operating losses for the trust were rolled over into the partnership. These losses allowed Conrad and his brother to reduce their federal income tax on their personal tax returns.

The IRS reviewed the brothers’ individual and trust tax returns and determined that the brothers should have used the $14 million discounted value that was calculated by the IRS for their father’s estate tax liability on the trust tax returns, which would limit the net operating losses that flowed through to the brothers’ personal tax returns.

The court applied the “duty of consistency” in holding that the brothers must use the estate tax value for the artwork for the trust and their personal tax returns. The “duty of consistency” only applies where (1) a taxpayer has made a representation, (2) the Commissioner has relied on the representation, and (3) the taxpayer has attempted to recharacterize the representation after the statute of limitations has run in such a way as to harm the Commissioner.

The taxpayer argued that if any “representation” was made it was made by the estate, not by Conrad. The court did not buy this argument because Conrad was the beneficiary and co-executor of the estate. Thus, the idea is that Conrad was an interested party with regard to the valuation. It would have been interesting if Conrad had not been the co-executor or trustee, but merely a trust beneficiary. In that case it would have been even harder for the court to argue that Conrad “represented” that the value of the artwork on his father’s estate tax return was $14 million and not $36 million.

While this case involved estate tax discounts associated with artwork, the same situation often arises with regard to estate tax discounts for real estate or ownership of small business interests. In each of these cases the game is to try to claim a lower valuation for estate tax purposes and a higher value when the property is later sold for federal income tax purposes. In many cases taxpayers plan on holding the assets for a period of time following the death of the owner so that they can claim that the disparity in the value of the asset for estate tax and income tax purposes resulted from appreciation in the assets that occurred after the owner’s demise.

Of course what beneficiaries are giving up in these scenarios is the stepped up tax basis in the inherited property, which results in a higher federal income tax liability upon the subsequent sale of the property. In most cases it is more beneficial for taxpayers to take the lower estate tax valuation regardless of the lower tax basis and ride out the waiting period because the federal estate tax rates are higher than the federal income tax rates. This is especially true given that the full step up in tax basis is set to be eliminated in coming years.

Perhaps the lesson to be taken from this case is that if the taxpayer is faced with this dilemma, they should remove themselves from the estate administration process so that they are not the taxpayer who is making the “representation” as to the lower estate tax value. Then once the time for assessing additional taxes has expired for the estate tax, the taxpayer can make a “representation” using the higher value for federal income tax purposes.

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