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Tax Court Values Deferred Annuity at Standard Mortality Tables

By : Espen Robak, CFA

Kite Stringing the IRS Along?
Estate of Kite Deploys Private Annuities to Reduce the Estate Tax Hit

In early 2001 Virginia V. Kite was 74 years old and, while not terminally ill, she was in poor health and wanted to do further estate planning. As a member of a prominent banking family in Oklahoma, she was both quite wealthy and sophisticated in business affairs, a sophistication that extended to trusts. She sought the advice of her family attorney who came up with a simple plan to ensure the transfer of additional assets out of Mrs. Kite’s trusts to benefit her children: a deferred private annuity.

The subject of Estate of Kite is, essentially, whether the eventual sales of assets in exchange for three private annuities were bona fide sales for full and adequate consideration.1  The transaction in question took place on March 30, 2001, or approximately three years before Mrs. Kite’s death. On this date, Mrs. Kite’s lifetime revocable trust sold its entire remaining interests in Kite Family Investment Co. (KIC), a Texas general partnership which in turn held certain notes and other interests in certain other holding companies for the Kite family (that in turn held publicly traded shares).2  The KIC interests, valued at approximately $10.6 million, were transferred in return for three deferred private annuities, one from each of Mrs. Kite’s children.3 

The Private Annuities

Each of the private annuities provided Mrs. Kite with approximately $1.9 million in income per year until her death, but with one important proviso: the annuity payments were only to start after ten years had passed. And there’s the rub: since no cash was ever paid under any of these annuity contracts, was this full and adequate consideration for the KIC interests transferred?

The IRS didn’t think so. Upon Mrs. Kite’s death, the Service issued two notices of deficiency determining a $6.0 million deficiency in Mrs. Kite’s gift tax return for 2001 and a $5.1 million deficiency in the estate tax return.

The Service argued the March 2001 transfer was really just a disguised gift to Mrs. Kite’s children.4  The Court held that it was not because the private annuities represented full and adequate consideration. But why? Certainly, the Service could not be faulted for looking askance at an arrangement that paid not a single cent to the decedent’s estate, while transferring more than $10 million in value out of the estate.

The Court’s Decision

As the decision of whether the March 2001 transfers were for full and adequate consideration is entirely dependent on the value of the annuities, that’s where the Court turns first. Specifically, was it appropriate for the decedent to have relied on standard mortality and valuation tables to value the annuities, when her health at the time was failing? In reaching the decision that it was reasonable, the Court relied on the McLendon5  decision and the following:

  1. As established in McLendon, the party attempting to depart from the tables has the burden of proving such departure is justified.
  2. The Regulations provide that the mortality component of the actuarial tables may not be used to determine the present value of an annuity if the measuring life is terminally ill. And terminal illness is defined as a condition where the resulting chance of death within one year is at least 50 percent.  
  3. While Mrs. Kite was in declining health as of the transaction date, she was able to get a letter from her physician attesting that he had examined and interviewed her at her home and “would anticipate that her longevity and health outlook is good for the next several years” and that she was “not terminally ill” nor did she have “an incurable illness or other deteriorating physical condition that would cause her to die within one year”. The physician estimated that her probability of surviving 18 months or longer was “at least 50%”. 
  4. While Mrs. Kite was receiving home health care beginning in 2001 and was incurring substantial medical expenses, the Court notes that the expenses was mostly due to Mrs. Kite’s decision to receive health care in her home (for example, her prescription drug expenses were minimal) and that her decision to receive health care at home could be explained by her affluence. 
  5. The Kite children were also affluent, after several rounds of gifts, and could have afforded to pay the annuity, at least for a while, had Mrs. Kite survived the ten-year deferral period. 
  6. Mrs. Kite had access to enough other assets that she didn’t really need the income flowing from the KIC interests and it was thus reasonable for her to “risk those interests for the potential profit from the annuity transaction.” The existence of her profit motive is further supported by her “position of independent wealth and sophisticated business acumen”.

It does seem quite a stretch to conclude, as the Court does based on the foregoing, that “Mrs. Kite and her children reasonably expected that she should live through the life expectancy determined by the IRS actuarial tables, which was 12.5 years”. It certainly seems, to this reviewer, that it is more reasonable to conclude that they expected she would not, and structured the transaction accordingly.7  However, if the standard in any case is only that she was expected to live more than a year, this may not be particularly important. And since the March 2001 transfer was for full and adequate consideration, the Court also rejects the respondent’s argument that the annuity transaction lacked economic substance.

Analysis

Did the Service make another unforced error here? Did this challenge, by providing such an easy win for the taxpayer, open up a huge new estate planning opportunity for the wealthy? The Court’s decision here provides wide leeway for such transactions going forward. There must be a substantial number of clients for whom life expectancy is more than one year, but where the probability of outliving a set number of years (could be any number of years) is negligible. Such clients would have the ability to transfer significant amounts with almost no risk of anything being pulled back into their estates after the deferral period is over.


1 Estate of Virginia V. Kite, et. al., v. Commissioner, TC Memo 2013-43 (February 7, 2013)
2 Mrs. Kite’s remaining ownership in KIC was valued at its liquidation value of $10,605,278, i.e., without applying any valuation discounts.
3 The annuity agreements were valued under the rates prescribed by Sec. 7520 and using IRS actuarial tables prescribed by Notice 89-24, 1989-1.
4 The Service, alternatively, also argued the transfer of certain trust assets constituted a disposition of the qualifying income interest so that this was a taxable gift of the remainder interest and that Mrs.   Kite made a taxable transfer under Sec. 2514 by releasing her general power of appointment over the corpus of another trust. These alternatives also failed to win the day for the IRS in this case.
5 135 F.3d 1017 (5th Cir. 1998), rev’g TC Memo 1996-307.
6 The Court also emphasizes that in McLendon, a taxpayer who had terminal cancer, received 24-hour home health care, and, according to his physician, had a 10% chance of surviving for more than one year (and had already attempted suicide by shooting himself in the head with a handgun) was not terminally ill for purposes of using the actuarial tables to value a private annuity.
The Court notes in its findings of facts that the annuity transaction was presented to the Kite children as an estate planning tool. This puts a further question mark next to the conclusion that Mrs. Kite’s sophisticated business acumen supports her profit motive in the transaction. It seems more reasonable to assume that, as many other sophisticated wealthy clients familiar with trusts and supported by quality estate planning services, her motive was not to make a profit and instead to move as much wealth from one generation to the next without incurring more estate and gift taxes than absolutely necessary.

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