Deck: Heirs to estates with lottery prizes and garden variety commercial annuities can be in for the tax shock of their lives

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1 Overline: Estate Planning & Taxation Headline: The Booby Prize Deck: Heirs to estates with lottery prizes and garden variety commercial annuities can be in for the tax shock of their lives Byline: By Noel C. Ice, partner, Cantey & Hanger, L.L.P., Fort Worth, Texas and Robert W. Goff, Jr., Shareholder, Sherrill, Crosnoe & Goff, a Professional Corporation, Wichita Falls, Texas. When an individual dies with an estate that is comprised primarily of property characterized by the Internal Revenue Code Section as income in respect of a decedent (IRD), 2 the combined federal income and estate tax liability is often so great, and so disproportionate to the heir s means, that it shocks not only the devisees but even the estate s personal representatives. When the IRD is a stream of payments for a specific term of years such as a lottery prize or a noncommercial annuity fair market value must be artificially determined for transfer tax purposes under the government s Section 7520 annuity tables. The aggregate tax liability of the estate may more aptly be experienced by the personal representative and devisees as nothing short of shock and awe. For example, the federal estate tax (FET) value under Section 7520 may be $12 million while the resale value of the right to receive those payments (if a sale is even possible) may be substantially less, and a sale of the annuity may be necessary in order to have the funds to pay the tax. Despite IRD deductions designed to alleviate some of this burden, the combination of federal income and estate taxes is confiscatory and should be changed. The point is that the FET value may far exceed the usual price that a willing buyer will pay for this type of asset. If, in the worst case, the executor had to sell the right to receive the lottery or structured annuity payments for less than half the value of the Section 7520 tables, the estate tax could exceed the proceeds of the sale. Fortunately, there is a regulation of somewhat limited application that could force the IRS to recognize the sales price for FET purposes; however, to date, this regulation: Treas. Reg. Section (d)(2) has not been discussed in the cases, and it is unclear how the IRS will respond. 1 All references herein to the Internal Revenue Code are to the IRC of 1986, as amended, unless otherwise indicated national office. 2 Treasury Regulations Section 691(a)-1 (2005) defines income in respect of a decedent (IRD) as those amounts to which a decedent was entitled as gross income but that were not properly includable in computing taxable income for the year ending with the date of his death or for a prior tax year under the method of accounting employed by the decedent. Items of IRD most often must dealt with in a decedent s estate are proceeds from qualified retirement plans (including individual retirement accounts), installment notes receivable and noncommercial annuities. -Page 1 of 15-

2 Prizewinner Lottery prize payments are included in gross income pursuant to IRC Sections 61 and 74(a). A lottery prize winner receives a taxable economic benefit when prize proceeds are placed in a separate fund for his benefit, even if the proceeds are to be paid later 3. But state lottery commission administrative rules generally avoid this economic benefit doctrine, even when the lottery commission purchases an annuity or bonds dedicated specifically to the payment of the prize owed to a non-cash option lottery winner. In most states a lottery winner is taxed only on the prize payments as he receives them. 4 His heirs are not so lucky. When the prize winner dies, his unpaid installments constitute IRD under IRC Section 691. These amounts are included in the income of his estate when received, whether or not the estate reports income on the cash or accrual method. As IRD, the lottery prize installments payable to the estate retain the same character as they would in the hands of the decedent had he been alive. But here s the rub: The installments are taxed at the rate applicable to the recipient (that is to say the estate or beneficiary of the estate). And there is no stepped-up basis on the unpaid balance of the lottery prize, because IRC Section 1014 does not apply to IRD property. Because the value of IRD such as a lottery prize is includible in the decedent s gross estate for federal estate tax purposes, the proceeds may be subject to a full measure of both federal income and federal estate tax. To provide taxpayers with some relief from this double tax burden, the IRC allows them an income tax deduction for the federal estate tax attributable to the items of IRD when it is received. This deduction must be claimed as an itemized deduction rather than a deduction from gross income in the calculation of adjusted gross income. 5 But the deduction is not subject to the 2 percent floor on miscellaneous itemized deductions by virtue of a special exception in IRC Section 67(b)(7). Despite the IRD deduction, the federal income and estate taxes are still too great. The fact that it is unavailable until the proceeds are received can be disadvantageous, since the estate tax is due immediately, and no credit is given with the loss of the time value of the money paid up front. Rules What exactly are the rules governing estate taxation of annuities and lottery prizes? Treasury Regulation Section (d)(1) provides: Except as otherwise provided in paragraph (b) of this section and Section 3 Cf. Rev. Rul , CB 193; PLR (Sept. 25, 1985). 4 TEX.GOV T CODE ANN. Section (Vernon 2004); PLR Rev. Rul , CB Page 2 of 15-

3 (b) (pertaining to certain limitations on the use of prescribed tables), if the valuation date for the gross estate of the decedent is after April 30, 1999, the fair market value of annuities, life estates, terms of years, remainders, and reversionary interests is the present value determined by use of standard or special section 7520 actuarial factors. These factors are derived by using the appropriate section 7520 interest rate and, if applicable, the mortality component for the valuation date of the interest that is being valued. For purposes of the computations described in this section, the age of an individual is the age of that individual at the individual's nearest birthday. See Section through The IRC does not provide a clear or universal definition of the term annuity. Treas. Reg. Section (b)(1)(ii) defines an annuity as the right to one or more payments extending over a period of time. And Treas. Reg. Section (b)(1)(i)(a) provides that an ordinary annuity interest is the right to receive a fixed dollar amount at the end of each year during one or more measuring lives or for some definite period. The Tax Court and each of the three federal appellate courts 6 that have addressed the issue of the estate taxation and valuation of a nontransferable lottery prize have concluded that the unpaid lottery installments are an annuity (actually a non-commercial, private annuity) for purposes of IRC Section A decedent s interest in a lottery prize is includable in the decedent s gross estate for federal estate tax purposes under IRC Sections 2031, 2033 and The bedrock premise of federal estate taxation is that all property included in a decedent s gross estate is to be valued at its fair market value. Fair market value is defined by Treas. Reg. Section (b) to be the price or value at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. There are statutory exceptions to the willing buyer-willing seller valuation methodology, the valuation of annuities under IRC Section 7520 and its regulations thereunder 7. IRC Section 7520 requires the application of government promulgated actuarial tables to value any noncommercial annuity, any interest for life or a term of years, or any remainder or reversionary interest. The actuarial tables ( 7520 tables ) are found in Treas. Reg. Section Under these tables, the fair market value of a private annuity is determined by a factor composed of an interest rate component and a mortality component. When the annuity is for a term of years as opposed to an interest for the life 6 U.S. Court of Appeals for the second Circuit in Gribauskas v. Comm r, 342 F.3d 85 (2d Cir. 2003); the Fifth Circuit in Cook v. Comm r, 349 F.3d 850 (5th Cir. 2003), 92 AFTR 2d ; the Ninth Circuit in Shackleford v. U.S., 262 F.3d 1028 (9th Cir. 2001); and Tax Court in Gribauskas v. Comm r, 116 T.C. 142 (2001), rev d on other grounds, 342 F.3d 85 (2d Cir. 2003). 7 Treas. Reg. Section (b). -Page 3 of 15-

4 of an individual, the mortality component is equal to the remaining term of years. The interest rate component is determined by using 120 percent of the federal midterm rate applicable to the calendar month in which the valuation occurs. The extra 20 percent is, in effect, a penalty valuation, if the federal midterm rate were, in fact, an accurate indication of value. While a specific facts and circumstances approach to valuation may be more accurate in a particular case, Section 7520 provides the exclusive method of valuation for interests subject to its provisions. Commercial Annuities Commercial annuities are taxed differently. A commercial annuity obtained from a company regularly engaged in the annuity business is valued under Treas. Reg. Section meaning that the value is the cost of purchasing a comparable contract from the issuing company, if available. If not available, then, unfortunately, the usually less favorable Section 7520 rate probably has to be used. Either method can result in a disaster if the 7520 value exceeds the actual resale value, or if the estate is forced to sell the annuity back to the company at far less than a new annuity would cost. Treas. Reg. Section (b) says: The value of annuities issued by companies regularly engaged in their sale, and of insurance policies on the lives of persons other than the decedent, is determined under Section Treas. Reg. Section (a)(1), in turn, provides: The value of a contract for the payment of an annuity, or an insurance policy on the life of a person other than the decedent, issued by a company regularly engaged in the selling of contracts of that character is established through the sale by that company of comparable contracts. If this regulation applies, the valuation is to be given by the insurance company on Form 712. Generally, we would want the regulations to apply, and have the annuity s replacement cost used, rather than its Section 7520 value because the 7520 value may exceed the replacement cost, depending on market conditions at the time. But what if the annuity has to be sold back to the insurance company in order to pay the tax? Suppose that the regulation applies and the value of purchasing a comparable commercial annuity is very high. Suppose further that the annuity is nontransferable. Even if an annuity is nontransferable, a company can always waive this requirement, which they frequently do if the policy is redeemed. Because the annuity company is the only potential buyer, the redemption price (what the estate receives when it is forced to sell back the annuity to pay the estate tax) will virtually always be less than the replacement cost (the estate tax value). This can make an estate with an annuity as a major asset a ticking time bomb, and an estate tax disaster. Imagine that there is only one asset in the estate: a commercial nontransferable annuity that would cost $10 million to replace, but for which the annuity company will pay only -Page 4 of 15-

5 $5 million if surrendered. If the annuity were surrendered for $5 million and taxed at $10 million, the beneficiaries (in 20006) would receive only $1.32 million after estate taxes, if the annuity were surrendered. This, in a year when the applicable exclusion is $2 million. And there are income taxes to be considered as well. This scenario is possible because the annuity company is the only market for the commercial nontransferable annuity. The estate tax on what is essentially a $5 million asset is $3.68 million, making the effective rate of tax is percent. I am told that the difference between what the annuity company will redeem an annuity for and what it will replace it for is not always as great as in the example. Nevertheless, it s a safe bet that there will be a substantial differential, with the replacement policy commanding the lesser price. This stands to reason, if only because new policies should reflect Americans longer life spans plus the company s special bargaining power in such situations. If the policy is not surrendered, the estate could have a huge liquidity problem, suggesting that even commercial annuities in an estate have substantial potential problems that an astute estate planner should recognize and plan for. Commercial annuities in structured settlements may be subject to Section 7520 instead Treas. Reg. Section (a)(1). And this may be good, bad or terrible, depending on the liquidity of the estate and the disparity ( which you can count on as a given) between (a) the willing buyer value (the real value, the one which ironically is virtually never available according to the IRS), (b) the replacement cost (if Treas. Reg. Section (a)(1) applies), or(c) the Section 7520 value (if Treas. Reg. Section (a)(1) does not apply). Because these regulations may be relied upon only if the annuity is a commercial annuity issued by a company regularly engaged in that business, these regulations might not cover a structured annuity payable to a plaintiff by a defendant in a tort settlement. Advisors therefore should be concerned that this result might obtain even if the defendant s obligation to pay is secured by a commercial annuity owned by the defendant; or, as is frequently the case, by a by a subsidiary of the liability insurance company that was responsible for insuring the plaintiff. We hope that this is a distinction without a difference, but we also must recognize that this fact pattern may be outside the literal purview of Treas. Reg. Section (b). Unfortunately, the posited facts are very similar to those in Technical Advice Memorandum , which stated, without mentioning Treas. Reg. Section , much less Treas. Reg. Section (d)(2), but relying entirely on Treas. Reg. Section (d), that Section 7520 should be used to value the right to receive payments under a structured annuity. According to TAM , the undiscounted Section 7520 value applied to the annuity, and not the replacement cost. In TAM , the situation, not uncommon in structured settlements, was that the terms of the settlement agreement required that Corporation Y, on behalf of Corporation X, purchase an annuity policy from Corporation Z, a life insurance company. Under the terms of the annuity policy, payments for the benefit of the decedent were to be made to the decedent's mother, as his guardian, for the longer -Page 5 of 15-

6 of the decedent's life or 30 years. 8 There are some statutory exceptions to the use of the 7520 Tables. According to Treas. Reg. Section (b)(2)(i), if the governing instrument cannot guarantee that the annuity will be paid over its entire term, the 7520 tables do not apply. Also, Treas. Reg. Section (b)(1)(ii) provides that if the annuity is subject to a restriction that affects its value, the 7520 tables do not apply. But the IRS has disregarded the exceptions. In fact, the IRS has steadfastly maintained that lottery winnings payable in the form of an annuity are to be valued under the 7520 tables. 9 The IRS has also consistently said that Congress, by enacting Section 7520, displayed a preference for convenience and certainty over accuracy in the individual case. The tables reflect an accurate measure of value only in the average case; they are not designed to be accurate or, for that matter, even equivalent to fair market value in a particular instance. But they are easily applied and produce standardized results. The government s ability to rely on actuarial tables was upheld in 1929 by the U.S. Supreme Court in Ithaca Trust. 10 In that case, the Supreme Court found that the application of actuarial tables precluded consideration of facts apart from those necessary to apply the tables. (Query: Is the value arrived at pursuant to the 7520 tables actually a present value rather than a fair market value?) Taxpayer challenges to the 7520 tables have been and will likely continue to be varied and imaginative. Some (particularly those made before the enactment 1988 of IRC Section 7520) attack the inadequacies and/or reasonableness of the interest rate component 11 or the mortality implicit in the tables. 12 Sometimes the argument has been that the asset or individual involved is unique and should not be valued using the assumptions in the tables. More recently, taxpayers have been successful in obtaining a judicial exception to avoid the application of the 7520 tables when they can show that, as the U.S. Court of Appeals for the Eighth Circuit put it in O Reilly v. Comm r: The valuation result is so unrealistic and unreasonable that either some modification in the prescribed method should be made, or complete departure from the method should be taken, and a more reasonable and realistic means of determining the valuation is available. 13 In Shackleford v. United States 14 the Ninth Circuit affirmed a district court s ruling that a 8 TAM See for example, TAM Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929). 11 Estate of Schildkraut v. U.S., 368 F.2d 40 (2d Cir. 1966); Bowden v. Commissioner, 234 F.2d 937 (5th Cir. 1956), cert. denied, 352 U.S. 916 (1956). 12 Dunigan v. U.S., 434 F.2d 892 (5th Cir. 1970); Fehrs v. U.S., 620 F.2d 255 (Ct. Cl. 1980). 13 O Reilly v. Comm r, 973 F.2d 1403, 1407 (8th Cir. 1992); See also Weller v. Comm r 38 T.C. 790, (1962). 14 Shackleford v. U.S., 262 F.3d 1028 (9th Cir. 2001). -Page 6 of 15-

7 decedent s estate was not required to use the 7520 tables to value a lottery prize for federal estate tax purposes. The lottery prize had 17 annual payments remaining at the decedent s death and, under local law, the lottery prize could not be assigned. 15 Based upon evidence submitted by expert valuation witnesses for both the taxpayer and the government, the court found that using the 7520 tables produced a substantially unrealistic and unreasonable result because the tables did not take into account the lack of marketability of the remaining installments of the lottery prize. 16 Under similar facts and reasoning, the Second Circuit in Gribauskas v. Commissioner 17 reversed the Tax Court and allowed the taxpayer to value, for federal estate tax purposes, 18 remaining annual installments of a lottery prize owned by the decedent at his death. That court held the 7520 tables must be rejected when their use produces a substantially unrealistic and unreasonable result. 18 Moreover, the Second Circuit refused to limit the unrealistic and unreasonable result exception to situations involving challenges to the interest rate assumptions and/or mortality assumptions of the 7520 tables, and expressly rejected the Tax Court s holding that prior case law did not support deviating from the actuarial tables on the basis of marketability restrictions alone, and that deviation... would undermine the policy favoring standardized actuarial valuation of annuities. 19 On the other side of the ledger, the Fifth Circuit has stuck with the 7520 tables. In Cook v. Commissioner, 20 the Fifth Circuit rejected the reasoning in Shackleford and Gribauskas and upheld the sanctity of the 7520 tables as the appropriate valuation method for a lottery prize. A split three judge panel of the court affirmed the Tax Court s holding that the 7520 tables must be used to value the decedent s remaining lottery payments for federal estate tax purposes. 21 This court distinguished Gribauskas by stating that, unlike Gribauskas, the record in Cook did not contain a stipulation that the lack of marketability of the lottery prize reduced its value. 22 The Fifth Circuit found that the lottery prize was properly characterized as a private annuity, and that the valuation of the prize under the 7520 tables was not unreasonable. 23 The court concluded that Congress did, in fact, display a preference for convenience and certainty over accuracy in the individual case when it enacted IRC Section Ibid at Ibid at Gribauskas v. Comm r, 342 F.3d 85 (2d Cir. 2003). 18 Ibid at Ibid 20 Cook v. Comm r, 349 F.3d 850 (5th Cir. 2003). 21 Ibid at Ibid at Ibid at Page 7 of 15-

8 Still, the majority opinion of the Fifth Circuit expressly stated that the applicability of the annuity tables is not unassailable. They must be used to value annuities unless it is shown that the result, is so unrealistic and unreasonable that either some modification in the prescribed method should be made, or complete departure from the method should be taken, and a more reasonable and realistic means of determining value is available. 24 The Fifth Circuit therefore recognizes in theory the applicability of the unrealistic and unreasonable test embraced by the Second and Ninth Circuits. It is simply that the majority of the panel in Cook did not find the absence of a lack of marketability discount sufficiently unreasonable to justify departure from the prescribed valuation method of IRC Section 7520 (i.e., the 7520 tables). Two federal district courts (Donovan and Anthony) recently agreed with the Fifth Circuit that lottery winnings must be valued by reference to the 7520 tables, without consideration of any discount for lack of marketability. 25 But not every lower court is following the Fifth Circuit s new lead. The most recent court to weigh in on the lottery prize valuation issue is a federal district court in New Hampshire (in the First Circuit) in David, Executrix of the Estate of Freeman v. United States. 26 In Freeman, both the IRS and the taxpayer (the estate of a New Hampshire decedent who won the Massachusetts lottery) asked the court to grant a summary judgment that the use of the 7520 tables to value the lottery prize for federal estate tax purposes was either required (IRS request) or inappropriate (taxpayer request). 27 The court refused to grant summary judgment in either party s favor, citing the existence of a genuinely disputed material fact (that is to say the fair market value of the annuity if a reliable valuation method other than the 7520 tables is used). 28 The government recently moved the New Hampshire court to reconsider its original opinion in Freeman I. 29 In Freeman II, 30 the court stated [c]ontrary to defendant s suggestion, the court has not determined that the applicable Treasury Regulation is invalid. Rather, consistent with the view embraced by several courts (including those cited by the government), it concluded that the law does not require blind adherence to the regulations when doing so would lead to an unreasonable or unrealistic result hardly a novel interpretation of the applicable law. The paramount goal of the Tax Code is, after all, to determine the fair market value of the asset in question (or, at a minimum, a reasonable approximation of 24 Ibid at Estate of Donovan v. U.S., 95 AFTR 2d (D. Mass. April 26, 2005) and Anthony v. U.S., 95 AFTR 2d (M.D. La. June 17, 2005). 26 Estate of Freeman v. U.S., No. 04-CV-273-SM, 2005 WL (D.N.H. Dec. 19, 2005). 27 Ibid. 28 Ibid at Davis, Ex. of Estate of Freeman, 97 AFTR 2d (DC NH, 2005). 30 Davis, Ex. of Estate of Freeman, 97 AFTR 2d (DC NH, 2006).. -Page 8 of 15-

9 its fair market value). 31 Interestingly, the court s opinion refusing summary judgment did adopt the unrealistic and unreasonable exception to the general rule that an annuity must be valued by reference to the 7520 tables, as enunciated by the Fifth Circuit in Cook. 32 To justify a departure from the 7520 tables, the federal court in New Hampshire indicated that the plaintiff (taxpayer) bears the burden of demonstrating: the value ascribed by the tables to the decedent s annuity is unrealistic and unreasonable; and there is a more reasonable and realistic means by which to determine its fair market value. 33 The court went on to say that the 7520 tables, by their very nature, fail to take into account the lack of marketability in determining the annuity s present value and that a non-assignable, non-marketable annuity has an inherently lower fair market value than a marketable annuity. 34 Nevertheless, the court decided it could not conclude as a matter of law that it is appropriate or inappropriate to use the 7520 tables to determine an approximate measure of the fair market value of the annuity in question. 35 Stay tuned! Where do the states fall in their estate tax valuations of lottery prizes? Texas has shown some mercy to the heirs of lottery prizes. As March 11, 1997, Texas Administrative Code Section (relating to the administration of the Texas Lottery Commission) allowed any estate of a lottery prize winner who died after that date to obtain a judicial order from the probate court directing the Texas Lottery Commission to accelerate the remaining unpaid installments of a lottery prize by making a lump sum payment to the estate to assist with the payment of federal estate (and correspondingly, at that time, State of Texas inheritance) taxes. The lump sum is the lesser of (1) the Texas Lottery Commission s book value (defined as the daily recalculated amortized cost of investments under the interest method) or (2) fair market value (defined as the value of investments at any time, determined by the market), reduced by administrative costs and applicable taxes. 36 Texas is not unique in its attempt to find a viable statutory solution to the Section 7520 problem that arises when a lottery winner dies, but the Texas experience is instructive. Effective Sept. 1, 1999, Texas Government Code Section (Vernon 2004) allowed prize winners to voluntarily assign all but the final two installments of a Texas 31 Ibid. 32 Ibid at Ibid at Ibid at Ibid at Tex. Admin. Code Section Page 9 of 15-

10 lottery prize. Any such assignment must be approved by the Travis County District Court. But approval is mandated if the prize winner and the assignee comply with certain administrative requirements set forth in Texas Government Code Section (Vernon 2004). Consequently, since Sept. 1, 1999 the owner of a Texas lottery prize has been free to sell all but the final two installments at whatever price can be agreed upon. Query: Does that make IRC Section 7520 inapplicable? Not necessarily. As with Shackleford and Gribauskas, the lottery prize in Cook was not assignable. In Cook, a Texas resident who was a lottery winner died in November 1995, before the 1997 amendment to the Texas Administrative Code and the 1999 enactment of Texas Government Code Section Because the lottery prize was not transferable when Gladys Cook died, her estate s primary argument for avoiding the application of the 7520 tables (that the 7520 tables failed to take into consideration a lack of marketability factor) was consistent with the successful arguments previously made by the taxpayers in Shackleford and Gribauskas. Yet the estate s argument did not persuade the majority of the Fifth Circuit s three judges who heard the case on appeal from the Tax Court. And if the Cook decision was not enough on its own to settle the issue, the enactment of Texas Government Code Section likely put an end, at least in Texas, to the argument that the 7520 tables are not sacrosanct insofar as lack of marketability is concerned. What new arguments might we expect in order to avoid the application of the 7520 tables to a lottery prize? One would be to reexamine the issue of whether the lottery prize should still be characterized as an annuity under IRC Section As IRC Section 7520 does not define the term annuity, the Fifth Circuit in Cook relied on the Tax Court s reasoning in Gribauskas to define an annuity by quoting Black s Law Dictionary as an obligation to pay a stated sum, usually monthly or annually, to a stated recipient. 37 It was at this point in its opinion that the Fifth Circuit (once again alluding to the Tax Court s Gribauskas) distinguished between a nontransferable lottery prize payable in yearly installments and nonannuity assets (that is to say notes receivable, leaseholds, patents and royalty payments), which share some characteristics with the lottery prize but have value dependent on market forces that affect the value of the underlying asset or the likelihood of continued payments. 38 The Fifth Circuit then defined a private annuity as a private annuity may be defined broadly, as the right to a series of fixed payments independent of market forces. 39 [Emphasis added.] Query: Does the fact that a lottery prize is freely assignable and a public market for such prizes exist change the character of a lottery prize from a non-transferable private annuity, as described in Cook, to an asset that has only some characteristics of an annuity? Another approach would be to argue, as the estate did in Cook, that a complete departure from the 7520 tables is appropriate because the artificial value derived from the Cook, supra note Ibid at Ibid. -Page 10 of 15-

11 tables, when compared to the actual value in the market place is so unrealistic and unreasonable. If a lottery prize is assignable, there is a public market for it. If the lottery prize is redeemable by the state, there is a private market. If the lottery prize is transferable, reasonable and realistic valuation alternatives to the 7520 tables are readily available. In all prior -reported cases, there was no market for the lottery prize (all such prizes were non-transferable) and the issue was whether an artificial valuation technique mandated by law (that is so say the 7520 tables) took into consideration the nonmarketability factor of the nontransferable private annuity. The taxpayer was, in essence, asking for a lack of marketability discount when, by stipulation and/or definition, no actual market existed. In Cook, the Fifth Circuit s decision was predicated in part on its determination that the non-marketability of a private annuity is an assumption underlying the tables despite being non-marketable. In footnote 8, the court further stated: For example, survivor annuities payable under qualified plans, the transfer of which is prohibited by ERISA. Treas. Reg. Section 26 CFR Section The court added that (GRATS); which are not marketable, are determined by use of the tables. See Treas. Reg. Section (c); (c)(1)(viii) and (c)(2) [T]he cases in which courts have seen fit to depart from the valuation tables have involved facts that disproved assumptions underlying the tables. The holdings in Shackleford and Gribauskas depart from that longstanding trend based on the premise that the right to alienate is fundamental to the valuation of any property. And the court pointed out in footnote 7: [T]herein lies the error of the Second and Ninth Circuits and the dissent which relies upon those decisions. This explicit split in the circuits makes the situation ripe for appeal to the Supreme Court. We hope the high court will answer the question:: Does the presence of a market for a lottery prize disprove the non-marketability assumption underlying the 7520 tables embraced by the Fifth Circuit in Cook and thus render the 7520 tables inapplicable? The IRS Digs In If the lottery prize or other annuity is transferable, is its valued fixed by its sale to a third party before filing and reporting the fair market value of the lottery prize on the decedent s federal estate tax return? It would appear that a bona fide sale of the lottery prize to an unrelated third party would unequivocally establish its fair market value (as it does for similar sales of other estate assets during administration). But the IRS has argued aggressively with us (to the point of the Dallas District Director s instructing the IRS estate tax attorney in the midst of an audit to request a TAM from the national office) that the 7520 tables must be used to compute the federal estate tax liability notwithstanding the purchase price actually received by the taxpayer in a bona fide sale of the lottery prize to an unrelated purchaser. In this case, the sale could have been consummated only with the agreement of IRS Collections to release the federal estate tax lien so all federal estate tax and federal income tax could be paid immediately. If a lottery prize is sold and the sale price received can be disregarded by the IRS for estate tax valuation purposes, -Page 11 of 15-

12 the results may indeed shock and awe not only the taxpayer but also his advisors who may have assisted in the sale without sufficient CYA letters and memos to the client describing the potential valuation dilemma. (See Name of Sidebar, p x.) [?] Don t expect much help from a state s redeeming the lottery prize. Under normal conditions, the market place should bring a higher value than the formula redemption price. Moreover, if a taxpayer is considering the redemption alternative, there s no reason to believe that the IRS will vary from its current litigation position that the 7520 tables, not the redemption price, apply to determine the value of the lottery prize for federal estate tax purposes. A Possible Solution There is a very narrow, but potentially extremely important, exception available to the taxpayer under Treas. Reg. Section (d)(2) that, if applicable, circumvents the IRS s argument that the valuation of a lottery prize must be made pursuant to the 7520 tables even if the taxpayer has received a lesser amount from the bona fide sale of the lottery prize. Under IRC Section 2053, an estate is entitled to a deduction equal to the difference between (1) the fair market value at which the lottery prize is included in the estate (presumably by application of the 7520 tables) and (2) the proceeds received from the sale of the prize. Treas. Reg. Section (d)(2) provides : Where an item included in the gross estate is disposed of in a bona fide sale (including a redemption) to a dealer in such items at a price below its fair market value, for purposes of this paragraph there shall be treated as an expense for selling the item whichever of the following amounts is the lesser: (i) the amount by which the fair market value of the property on the applicable valuation date exceeds the proceeds of the sale, or (ii) the amount by which the fair market value of the property on the date of the sale exceeds the proceeds of the sale. The principles used in determining the value at which an item of property is included in the gross estate shall be followed in arriving at the fair market value of the property for purposes of this paragraph. [Emphasis added.] The last sentence of this regulation indicates that if the 7520 tables are used to determine the fair market value at which the particular asset is included in the gross estate, then the same value must be used to determine the size of the allowable deduction when the asset is sold for less than its fair market value. For this regulation to apply, the sale must be for estate administration purposes and to a dealer in the type of asset sold. The instances in which Treas. Reg. Section (d)(2) have been cited do support its application in the context of the sale or redemption of a lottery prize. In Joslyn v. Commissioner 40 the issue involved the allowance of a deduction for underwriting expenses incurred in order to complete the sale of a large block of stock in the over-thecounter market. The IRS argued that the regulation in question was merely a limitation on 40 Joslyn v. Comm r, 63 T.C. 478 (1975), rev d on other grounds, 566 F.2d 677 (1977). -Page 12 of 15-

13 the first two sentences of the paragraph in the regulation dealing with selling expenses 41. The Tax Court disagreed and discussed the history of the regulation: The sentence concerning a sale to a dealer was not added until 1965; it was not added as a result of any new statutory limitation. The new sentence was added to section (d)(2) at the same time as the amendment of sections through , relating to the valuation of property included in an estate, and it is apparent that the amendment of section (d)(2), allowing a deduction for a sale at a loss, was a corollary of the adoption of new rules for the valuation of property included in the estate. See T.D. 6826, C.B Thus, the third sentence of Treas. Reg. Section (d)(2) was added to provide relief precisely for the taxpayer with property that (a) is included in the gross estate at one value, (b) is unable to be sold by the estate for that value, and (c) as a consequence is sold at a loss (relative to fair market value) for administrative reasons. 43 We relied on this inconspicuous regulation for a taxpayer s negotiations with the IRS national office to settle a Texas lottery prize valuation. The national office was going to issue a TAM adverse to the taxpayer when we were able to point out the existence and applicability of Treas. Reg. Section (d)(2). 44 The case was resolved on the condition that the taxpayer agree with the IRS that the request for the TAM be withdrawn. Be warned, though, there is a very important practical consideration when making a voluntary assignment of some part of a lottery prize: the time and expense involved in accomplishing the assignment particularly if the lottery prize is being sold to pay transfer taxes and/or administration expenses. In most cases, the purchaser will require the release of the federal estate tax lien burdening the lottery prize before consummating the sale. To accomplish that, the taxpayer must deal with at least the IRS estate tax attorney handling the estate tax audit (and quite possibly the district director). If he s fortunate, he s get an IRS collections officer who is familiar with annuities and lottery prizes and will coordinate the release and application of the sales proceeds among the IRS estate tax division, the IRS income tax division and the taxpayer. This likely will not occur without some indemnification agreement from the estate s personal representative and the agreement of the purchaser to wire funds as directed by the IRS collections officer. Expect this administrative process to be cumbersome, lengthy, expensive and frustrating. 41 Ibid at Ibid at Cartwright v. U.S., 323 F.Supp 769, 773 (W.D. NY 1971); GCM Specific credit and a great deal of thanks are owed by the authors to Robert B. Coplan of Southern Wealth Management LLP in Dallas, Texas (and formerly of Ernst & Young LLP in Washington, D.C.) for his help and assistance in identifying this very narrow but exceedingly important regulatory jewel and successfully arguing its application before the IRS. -Page 13 of 15-

14 Given the potentially harsh and unfair results of a sale that does not fall within the narrow confines of Treas. Reg. Section (d)(2), should a taxpayer contemplating a sale of an annuity or lottery prize consider requesting a private letter ruling that the regulation does apply? Perhaps. Conclusion By enacting IRC Section 7520 in 1988 with its mandated review and revision of the mortality component of the 7520 tables on a 10 -year basis and the interest rate component of the 7520 tables on a monthly basis, Congress made a policy decision that the certainty and simplicity achieved in the valuation of certain items of property by use of the 7520 tables was preferable to a facts and circumstance analysis in each individual case. Eighteen years later, though, the law is anything but settled, at least insofar as the valuation of a lottery prize is concerned and the same is true for all other noncommercial annuities. All courts examining the issue have concluded that the unpaid installments of a nontransferable lottery prize are in the nature of an annuity, as that term is used in IRC Section But the courts have diverged on whether the 7520 tables are the exclusive valuation method in each and every case. Notwithstanding the policy decision underlying the 7520 tables, each of the three federal appeals courts that considered facts -and -circumstances evidence showing the significant variance from the value produced by the 7520 tables either relied upon the unrealistic and unreasonable judicial exception to the 7520 tables and ruled for the taxpayer or embraced the exception but did not find the variance sufficient to justify its application. These opinions seem to reflect a judicial perception that the 7520 tables produced unfair results in these particular cases. However, the trend may signal a departure from the presumption that the 7520 tables trump specific facts and circumstances in every case. Case Study The case study attached as Addendum A illustrates the severity of the combined income and transfer tax burden of a lottery prize in the hands of a decedent. As might be expected by estate planners, the most egregious result depicted by the case study occurs when there is an absence of estate planning and a generation-skipping transfer which triggers generation-skipping transfer tax liability. This adds yet a third layer of tax to all or some part of the lottery prize. Given these facts, the skip person beneficiaries of the lottery prize may not be quite as rich as they hoped. The most surprising thing shown by the calculations in the Addendum is that the most economic approach would be to hold on to the lottery proceeds. This is because the secondary market for such annuities is not very competitive, and if invested, you can be sure that the rate of return will be less than the lottery proceeds produce; otherwise, no one would buy it. Secondly, and somewhat ironically, although 120% of the federal mid- -Page 14 of 15-

15 term rate is unrealistically high (by, say, 20%, if you invest in government mid-term bonds), this has the odd effect of reducing (rather than increasing) the value for FET purposes. Obviously if the rate were zero, the FET value would be equal to the payments, since an amount of money invested at a zero rate of return produces the same amount as the investment. The same principle applies as the rate goes up. The greater the assumed rate of return, the less the sum of money (its FET value) needed to produce the stream of payments. The problem is that if you can and do sell the annuity for less than the FET value, you are certainly less well off that if the sales price were equal to or greater than the FET value, and that is unlikely to happen if the FET value is inextricably tied to the 7520 rate. -Page 15 of 15-

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