By Peter C. Barton, JD, CPA, and Clayton R. Sager, PhD, CPA, University of Wisconsin-Whitewater
In Sather v. Comm'r, the Tax Court ruled that the reciprocal gifts in trust that three brothers and their spouses made to their nieces and nephews were not eligible for the annual gift tax exclusion. Sather demonstrates the importance of obtaining competent tax advice on wealth transfer. With a booming economy and more than 12,000 Americans turning age 50 every day, this is a timely topic.
IRC section 2511(a) states that the gift tax applies "whether the gift is direct or indirect." IRC section 2503(b) allows each donor a $10,000 annual exclusion per donee, which is indexed for inflation in $1,000 increments beginning in 1998. In Sather, Larry, John, and Duane Sather were advised by a former Big Five tax partner on transferring their stock in Sathers, a family-owned candy business, to the next generation. The Sather brothers were married, and each couple had three children.
The Sathers made the following gifts in 1992 and 1993. Larry and his wife transferred stock into the Larry trust for their children and into the John and Duane trusts for John and Duane's children. John and his wife transferred stock into the John trust for their children and into the Larry and Duane trusts for Larry and Duane's children. Duane and his wife transferred stock into the Duane trust for their children and into the Larry and John trusts for Larry and John's children. Each couple's 1992 gifts to their own children exceeded the annual exclusion, but they used the IRC section 2505(a) unified credit and reported no gift tax. All gifts to each niece and nephew from each spouse were slightly under $10,000 per year, resulting in no gift tax.
The IRS claimed that each couple's gifts to their nieces and nephews were in reality gifts to their own children. Therefore, the IRS disallowed all annual exclusions for the gifts to the nieces and nephews, which amounted to almost $60,000 per spouse per year. The IRS assessed the donee trusts for the unpaid gift tax under IRC section 6324(b), which contains a 10 year statute of limitations.
The Tax Court upheld the disallowance of the exclusions. Citing the application of the gift tax to indirect gifts and Furst v. Comm'r (TC Memo 1962-221), the court ruled that "the simultaneous, circuitous transfers of identical property" to the nieces and nephews constituted gifts by the transferors to their own children. The nieces and nephews would have been in the same economic position had their parents made the gifts directly to them. The Tax Court also relied on United States v. Estate of Grace [395 U.S. 316 (1969)], where spouses created trusts for each other. Under the reciprocal trust doctrine, a trust settlor is treated as the creator of a trust that is in form created by another if two trusts are interrelated and leave the settlors "in approximately the same economic position" as they would have been had they named themselves as beneficiaries. However, the Tax Court's ruling in Sather did not depend on gifts in trust since no trusts were involved in Furst, where the facts were otherwise similar.
The Tax Court in Sather appears to prohibit all indirect gifts to a donee where the donor has already claimed the annual exclusion for a gift made directly to that donee. The best approach is for parents and grandparents to start making gifts when the donees are young to obtain the maximum years of annual exclusion. *
Cite: Sather v. Comm'r, TC Memo 1999309 (September 17, 1999).
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