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Estate of Charles W. Smith v. Commissioner of Internal Revenue

decided: November 3, 1977.


On Appeal From the Decision of the United States Tax Court.

Cummings, Sprecher, and Wood, Circuit Judges.

Author: Per Curiam

The Commissioner of Internal Revenue has appealed from an adverse decision of the Tax Court. The Commissioner determined a deficiency in the estate tax of Charles W. Smith's estate in the amount of $646,700.50. The deficiency resulted from a disallowance of $1,330,101.62 of a claimed marital deduction of $1,521,245.86. After paying the assessed amount, Smith's estate sued for a refund on the ground that the marital deduction should have been allowed.

Decedent's 1967 inter vivos trust contained an "equalization clause" under which his surviving spouse would take nothing if the values of assets owned by her at his death were subsequently determined, by calculations that could not be made until one year later, to be in excess of certain amounts. The Commissioner insisted that because the amount passing under this provision might be decreased as a result of valuation changes in the alternate valuation period,*fn1 the wife's interest was contingent and therefore constituted a "terminable interest" under Section 2056(b)(1) which would fail to qualify for the marital deduction for federal estate tax purposes.*fn2

The Tax Court, in an opinion by Judge Drennen reviewed by the full Court,*fn3 held that the equalization clause did not create a terminable interest problem requiring the disallowance of the marital deduction under Section 2056(b)(1). 66 T.C. 415 (1976). Consequently, based on the Commissioner's final computations, taxpayer was awarded $2,907.25 as its estate tax overpayment (App. 45a). We affirm.

The stipulated facts may be summarized as follows: Charles W. Smith (decedent), a Michigan resident, died in 1970. In 1967, he had established a revocable inter vivos trust with the Northern Trust Company of Chicago as Trustee. His federal estate tax return reported a gross estate of about $3,500,000. The assets of the trust amounted to approximately $3,300,000.

On decedent's death, Article IV of the trust divided the trust assets into a "Marital Portion" and a "Residual Portion." The Marital Portion was to be held as a Marital Trust designed to qualify for the marital deduction under the federal estate tax laws pursuant to Section 2056 of the Internal Revenue Code. Under the terms of the Marital Trust, decedent's surviving spouse was to receive all the net income for her lifetime, with a special power of appointment over corpus exercisable by deed and a general power of appointment exercisable by will. Decedent's wife, Alice M. Smith, died shortly more than one year after her husband. The critical provision of Article IV of the trust is the "equalization clause." Its purpose was to equalize the size of the estates of Mr. and Mrs. Smith in order to minimize the total combined federal estate taxes on both estates.

Article IV of the trust, dealing with distribution upon decedent's death, provided for allocating to the Residual Portion any assets with respect to which the marital deduction would not be allowed if allocated to the Marital Portion. Article IV then provided:

"(b) There shall then [after allocation of the Residual Portion] be allocated to the Marital Portion that percentage interest in the balance of the assets constituting the trust estate which shall when taken together with all other interests and property that qualify for the marital deduction and that pass or shall have passed to Settlor's said wife under other provisions of this trust or otherwise, obtain for Settlor's estate a marital deduction which would result in the lowest Federal estate taxes in Settlor's estate and Settlor's wife's estate, on the assumption Settlor's wife died after him, but on the date of his death and that her estate were valued as of the date on (and in the manner in) which Settlor's estate is valued for Federal estate tax purposes ; Settlor's purpose is to equalize, insofar as possible, his estate and her estate for Federal estate tax purposes, based upon said assumptions." (Emphasis added.)

The equalization clause contained in Article IV(b) is the only one at issue.

Decedent's estate tax return claimed a marital deduction of $1,521,245.86, representing the value of the Marital Trust as determined by the estate, plus the value of certain other property interests passing to Mrs. Smith outside of the trust. The estate determined that had Mrs. Smith died after decedent, but on the same day, her individual gross estate, including all assets received from decedent outside the trust, would have had a value of $667,331.47 on the date of decedent's death. Under this assumed fact situation, the value of Mrs. Smith's gross estate would have been $813,630.17 one year from the date of her husband's death, the alternate valuation date. See note 1, supra. On that date, the values of both decedent's estate and the assumed estate of his wife were higher than the date-of-death values. Consequently, in accordance with the terms of the trust, the estate utilized date-of-death values for federal estate tax purposes and for computing the value of the assets in the marital trust.

The Commissioner took the position that the property interest passing from decedent to his wife under the trust was a terminable interest under Section 2056(b)(1) (note 2, supra) and therefore determined an estate tax deficiency in the amount of $646,700.50. Of the entire Tax Court, only Judge Irwin agreed that Mrs. Smith's interest was a nondeductible terminable interest, and he "reached this conclusion reluctantly" (66 T.C. at 436) in this case of first impression.

First of all, the Commissioner admits that the equalization clause is not a tax avoidance measure, for estate taxes will still be collected from the estate of each spouse and none of the funds will escape taxation. The clause does have the effect of minimizing the total combined federal estate taxes on both estates by treating the assets of each spouse as if it were pure community property. Such a clause is frequently used in estate planning. See 1 Casner, Estate Planning 785 and Supplement (3d ed. 1961). Government counsel candidly admitted at the oral argument that there are no policy grounds for vitiating such a clause. This litigation was brought ostensibly because supposedly required by the literal language of Section 2056(b).

As taxpayer has put it (Br. 4-5), if decedent's estate had a value of $2,000,000 on the selected valuation date and Mrs. Smith's "estate" then had a value of $400,000, the amount passing to her under the equalization clause would be ...

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