In United States v. Elaine T. Marshall, et al., No. 12-20804 (5th Cir. Aug. 19, 2015), the U.S. Court of Appeals for the Fifth Circuit reversed in part and affirmed in part a decision from the U.S. District Court for the Southern District of Texas regarding the tax liability of indirect gifts of stock made to shareholders. While it affirmed the district court’s ruling on donee liability for gift taxes, including upholding liability on the donor’s ex-wife as a trust beneficiary of the indirect gift, it reversed the district court’s judgment relating to the amount of that liability. Specifically, the Fifth Circuit held that a donee’s liability for a donor’s unpaid gift tax and interest is capped by the amount of the gift, that is, $84,191,754 (the fair market value (FMV) of the gift). The Fifth Circuit further held that an executor and trustee were liable for certain amounts they set aside without first paying the gift tax, but it reversed the district court and held that an executor didn’t breach his fiduciary duty under state law with respect to the estate’s creditors.
The Gifts of Stock
In 1995, J. Howard Marshall, II made indirect gifts of Marshall Petroleum, Inc. (MPI) stock to five MPI shareholders. The gift recipient shareholders consisted of: 1) J. Howard’s ex-wife, Eleanor, who was the beneficiary of a trust funded by MPI stock; 2) J. Howard’s son, E. Pierce; 3) E. Pierce’s wife, Elaine; 4) the Preston Marshall Trust (Preston Trust), formed for the benefit of J. Howard’s grandson, Preston; and 5) the E. Pierce Marshall, Jr. Trust (E. Pierce Jr. Trust), formed for the benefit of J. Howard’s grandson, E. Pierce Marshall, Jr.
Procedural Determinations
In 1995, J. Howard sold his MPI stock back to MPI, at a price below its FMV. The sale increased the value of MPI stock for the remaining MPI shareholders. In 2002, the Internal Revenue Service audited the estate, and the parties entered into a stipulation that J. Howard’s 1995 indirect gifts, which totaled $84,191,754, consisted of : 1) $43,768,091 to E. Pierce; 2) $35,939,316 to Eleanor: 3) $1,104,165 to Elaine: 4) $1,104, 165 to the Preston Trust; and 5) $1,104, 165 to the E. Pierce Jr. Trust. J. Howard never paid any gift taxes and died within a short time after making the gifts.
After executing the stipulation, J. Howard’s estate continued to avoid paying the gift tax of $47,509,047 plus statutory interest, and the IRS attempted to collect the unpaid tax from the donees. In 2006, E. Pierce died, and his estate paid about $45 million towards the unpaid gift tax for the benefit of all of the donees except Eleanor. Eleanor died in 2007, and E. Pierce Jr. became executor of her estate; Finley L. Hilliard (Hilliard) became the trustee for a living trust that she had set up to hold her MPI stock. The living trust was eventually split into three charitable remainder annuity trusts and one grantor retained income trust (GRIT). Although they were both aware that Eleanor’s estate could be liable for unpaid gift tax, E. Pierce Jr. and Hilliard made distributions of personal property, paid rent, legal fees and accounting fees and set aside funds for charitable purposes. E. Pierce and Hilliard didn’t pay any gift tax, disputing that she was even a beneficiary of the gift.
In 2008, the U.S. Tax Court determined that J. Howard was deficient in paying taxes for the 1995 gifts. His estate continued to not pay the taxes due.
The IRS sued the five donees in 2010 in district court to recover the unpaid gift taxes and interest. It also sought recovery under 31 U.S.C. Section 3713 (the Federal Priority Statute) from E. Pierce Jr. and Hilliard, both of whom paid other debts from Eleanor’s estate before paying the gift tax liability to the IRS. Her estate moved for summary judgment, arguing that: 1) Eleanor wasn’t a donee of J. Howard’s gift—the GRIT was the donee and therefore liable for gift tax; 2) alternatively, E. Pierce Jr., as remainder beneficiary, was the donee of the gift; and 3) Kansas law applied and therefore, the increased value of the MPI shares should be allocated to corpus (and thus to the remainder beneficiary). The IRS moved for summary judgment against Eleanor’s estate, arguing that the stipulation and Tax Court determination barred it from litigating its claims. The IRS also moved for partial summary judgment for liability against Elaine in her individual capacity as executrix of E. Pierce’s estate, as trustee of the Preston Trust, and as trustee of the E. Pierce Jr. Trust. Elaine filed a cross-motion for summary judgment, arguing that IRC Section 6324(b) capped all donee liability at the total value of the gift received.
In March 2012 and June 2012, the district court issued multiple rulings: 1) the donees’ debts under Internal Revenue Code Section 6324(b) were independent from J. Howard’s unpaid gift tax liability, and the donees incurred interest on that independent liability; 2) Eleanor was a donee of J. Howard’s gift; and 3) Hilliard and E. Pierce Jr. were individually liable for debts paid as executor and trustee before paying the gift tax liability owed to the IRS. The parties appealed.
Donee Status of Eleanor
The Fifth Circuit first addressed whether res judicata, based on the stipulation and Tax Court decision, barred Eleanor’s estate from contesting Eleanor’s status as donee or the value of the gift. Applying a four-part test articulated in Meza v. Gen. Battery Corp., 908 F.2d 1262 (5th Cir. 1990) regarding when res judicata applies, the Fifth Circuit found that res judicata didn’t bar Eleanor from contesting whether she was a donee. However, res judicata did bar her from contesting the value of the gift.
As to whether Eleanor was a donee, the Fifth Circuit rejected each of Eleanor’s arguments. Her first claim was that neither she nor the GRIT was a donee because neither of them received a present interest in property when J. Howard sold his stock back to MPI. Her estate claimed that she and the GRIT were unable to access the increased value of the shares, and there was a “postponement of enjoyment” that made the gift a future interest. Rejecting this argument, the Fifth Circuit held that the indirect gift was a transfer of a present interest: a shareholder’s transfer of property to a corporation for less than full consideration is generally a gift to the individual shareholders. There was no uncertainty regarding the identity of any of the shareholders who benefited from the gift, and, stated the court, Eleanor herself “admits that she received additional distributions after JHM’s gift.”
Eleanor’s estate next claimed that Eleanor wasn’t a donee because the trustee, or alternatively, the remainder beneficiary, was the donee. Eleanor’s estate argued that trustees, not beneficiaries, are transferees for purposes of estate tax liability. The court rejected that argument, agreeing with the IRS that there are clear differences between estate tax liens and gift tax liens. Moreover, to determine who qualifies as a donee for purposes of the gift tax exclusion, the court looked to the U.S. Supreme Court’s decision in Helvering v. Hutchings, 312 U.S. 393 (1941), in which it ruled that when a donor makes a gift to a trust, “the beneficiary of the trust is the donee.” “Helvering tells us that the beneficiary of the trust is the donee for purposes of gift tax,” stated the Fifth Circuit.
Next, the Fifth Circuit rejected Eleanor’s estate’s claim that the remainder beneficiary should share responsibility for the unpaid gift tax. Noting that this argument appeared to be a thinly veiled attempt to argue about the amount of the gift Eleanor received, res judicata barred Eleanor’s estate from relitigating the terms of the stipulation and the Tax Court decision. And, finally, the court rejected the argument that the ordinary course of business exception applied, in that the IRS didn’t prove that there was donative intent. Eleanor’s estate relied on cases in which courts inferred donative intent between a donor and shareholders based on close family relationships. In this instance, Eleanor’s estate argued, Eleanor was divorced from J. Howard for more than 35 years, and each had remarried. Thus, the estate said, there wasn’t a close family relationship and therefore, no gift. The Fifth Circuit disagreed: “The term gift is used in a very broad sense when talking about the gift tax.” The stipulation and the Tax Court decision made clear that J. Howard made a gift to Eleanor. As such, her estate couldn’t argue that J. Howard didn’t make a gift to her.
Liability of Hilliard and E. Pierce Jr.
Liability under the Federal Priority Statute requires that: 1) a fiduciary, 2) distributed the estate’s assets before paying a claim of the government, and 3) knew or should have known of the government’s claim (U.S. v. Renda, 709 F.3d 472, 480-481 (5th Cir. 2013)). The issue was whether Hilliard and E. Pierce Jr. met the knowledge element; actual knowledge isn’t required. Both Hilliard and E. Pierce Jr. knew of the potential liability to the IRS; therefore, the Federal Priority Statute was applicable.
As to their personal liability, E. Pierce Jr. claimed that if the IRS disallows Eleanor’s estate’s funds that were set aside for charitable purposes, then those funds would be freed up to pay the gift tax liability. However, stated the Fifth Circuit, even if the charitable set-aside funds could be returned, the Federal Priority Statute still wouldn’t limit their liability.
Moreover, E. Pierce Jr. was individually liable for selling personal property from Eleanor’s estate because he distributed proceeds from the sale before paying the debt to the IRS, in violation of the statute. As to rent paid on Eleanor’s vacant apartment, E. Pierce Jr. claimed that the expense was a funeral expense; it was made so that he could hold a memorial service in Eleanor’s home. The district court had accepted that argument as true, and the Fifth Circuit agreed with the district court’s assessment. However, the district court also held that only the first $15,000 of funeral expenses from the estate may be payable before paying the IRS (under Tex. Est. Code Ann. Section 355.103).
However, disagreeing with the district court, the Fifth Circuit held that E. Pierce Jr. didn’t breach his fiduciary duties under state law because he didn’t owe a fiduciary duty to Eleanor’s estate’s creditors. Because Texas law conflicts on whether an executor owes a fiduciary duty to an estate’s creditors, and the Texas Supreme Court hasn’t ruled on that issue, the Fifth Circuit had to “guess” what the Texas Supreme Court would do. Looking to FCLT Loans, L.P. v. Estate of Bracher, 93 S.W.3d 469 (Texas App. Houston 14th Dist. 2002) for guidance, the Fifth Circuit held that there doesn’t seem to be a reason why an independent executor’s fiduciary duty to an estate should be expanded to include a duty to the estate’s creditors. Accordingly, it held that E. Pierce Jr. didn’t owe Eleanor’s estate’s creditors a fiduciary duty under Texas law and therefore, he didn’t breach his state law fiduciary duties.
As to Hilliard, the Fifth Circuit found him personally liable for the amount he caused the trust to pay in legal and accounting services on behalf of other charities. Under Texas law, accounting and legal fees are payable before debts to the IRS if they’re incurred in preserving, safekeeping and managing the estate. In the instant case, the fees were for the benefit of other organizations, not Eleanor’s estate. As such, the Fifth Circuit found that the district court was correct in finding Hilliard personally liable for paying the accounting and legal fees.
Amount of Liability
While the remaining donees recognized that they were liable for the gift tax under IRC Section 6324(b), they argued that their personal liability was limited to the value of the gifts they received. The IRS, however, argued that they’re personally liable for almost $75 million beyond the gifts’ value, consisting primarily of accrued interest on the unpaid tax liability from 1995. The district court had agreed with the IRS. The Fifth Circuit reversed.
The Fifth Circuit noted that Section 6324(b) is the sole basis under the Tax Code to impose liability on a donee for gift taxes unpaid by a donor:
(b) Lien for gift tax.—Except as otherwise provided in subsection (c) [not applicable in this case], unless the gift tax imposed by chapter 12 is sooner paid in full or becomes unenforceable by reason of lapse of time, such tax shall be a lien upon all gifts made during the period for which the return was filed, for 10 years from the date the gifts are made. If the tax is not paid when due, the done of any gift shall be personally liable for such tax to the extent of the value of such gift.
The Fifth Circuit stated that neither party disputed the use of the word “tax” in the above section includes interest. The question, stated the court, was the meaning of the last sentence. After providing examples of how the above section would be applied, the court concluded that “the natural reading of this sentence is that a donee’s personal liability is capped at the amount of the gift.”
The IRS, however, argued that the donees’ liability for interest above the value of the gifts is supported by IRC Sections 6601 and 6901(a) (which provides that the amounts of a donee’s liability relating to gift tax are to be assessed and collected in the same manner as in the case of taxes to which the liabilities were incurred.) Rejecting the IRS’ argument, the Fifth Circuit noted that these sections are procedural in nature and not substantive. As such, they’re inapplicable to make a determination of the extent of the donees’ liability. Furthermore, the court ruled that longstanding rules of construction mandate that if the words of a tax statute are in doubt, “the doubt must be resolved against the government and in favor of the taxpayer.”
The Fifth Circuit stated that its interpretation is consistent with the Third Circuit (regarding gift tax) and the Eighth Circuit (regarding estate tax) in which both circuits have ruled that a transferee’s or donee’s liability is limited to the value of the transfer of property or gift, respectively. It did note, however, that the Eleventh Circuit takes the opposite view in the context of liability for estate tax.
The Fifth Circuit further rejected the IRS’ distinction between interest that accrues on underlying gift tax liability and on a donee’s personal liability under Section 6324(b). “A donee’s personal liability under [Section] 6324(b) is anchored solely and is referable on to, the unpaid gift tax and interest thereon,” stated the court.